Return and volatility transmission between world oil

prices and stock markets of the GCC countries

Mohamed El Hedi Arouri
LEO, University of Orlans & EDHEC Business School
Rue de Blois - BP 6739, 45067 Orlans Cedex 2, France
Email: mohamed.arouri@univ-orleans.fr Phone: +33.2.38.49.24.10 Fax: +33.2.38.41.73.80
Amine Lahiani
LEO, University of Orlans and ESC Rennes Business School
Rue de Blois - BP 6739, 45067 Orlans Cedex 2, France
Email: amine.lahiani@univ-orleans.fr Phone: +33.2.38.49.24.10 Fax: +33.2.38.41.73.80
Duc Khuong Nguyen
*
ISC Paris School of Management
22, Boulevard du Fort de Vaux, 75017 Paris
Email: dnguyen@groupeisc.com Phone: +33.1.40.53.99.99 Fax: +33.1.40.53.98.98
*
Corresponding author
Abstract
This paper investigates the return linkages and volatility transmission between oil and stock markets
in the Gulf Cooperation Council (GCC) countries over the recent period 2005-2010. We employ a re-
cent generalized VAR-GARCH approach which allows for transmissions in return and volatility. In
addition, we analyze the optimal weights and hedge ratios for oil-stock portfolio holdings. On the
whole, our results point to the existence of substantial return and volatility spillovers between world
oil prices and GCC stock markets, and appear to be crucial for international portfolio management in
the presence of oil price risk.
Keywords: oil and stock markets, optimal hedge ratios, VAR-GARCH models
JEL classifications: G12, F3, Q43
2
1. Introduction
Dynamic return links and volatility transmission across capital markets are of greater
and greater interest to the financial community with the increasing trend of financial
globalization throughout the world. If, for example, return and volatility are found to
spread from one market to another, portfolio managers and policymakers would have
to adjust their actions to essentially prevent contagion risks in the event of market
crashes or crises. This issue has been extensively investigated in the context of inter-
national asset markets (e.g., Forbes and Rigobon, 2002; Syriopoulos, 2007 for stock
markets; Barassi et al., 2005; Wang et al., 2007 for monetary markets; and Skintzi
and Refenes, 2006; Johansson, 2008 for bond markets). These studies generally find
evidence of significant return and volatility spillovers across markets, and argue that
the degree of spillover is highly dependent on economic and financial integration as
well as on the coordination of monetary policy.
Expanding this issue to the context of oil and stock markets is also important
because empirical results offer insights into building accurate asset pricing models
and accurate forecasts of the volatility of both markets. In particular, all investors
should know how the value of their portfolios is affected by large variations observed
in oil prices over the last decade. Indeed, oil price fell to less than $20 a barrel in De-
cember 2001 following the world economic downturns, and then increased to reach
more than $130 in June 2008. This continuum and rapid swings in oil prices lead to
significant modifications in energy risk management and policies of almost all coun-
tries, as oil is used as a pricing benchmark for various financial instruments and plays
a crucial role in international asset hedging strategies for a variety of economic
agents (e.g., investors holding stocks of oil and oil-related industries, oil producers
3
and consumers, and so on). These stylized facts also raise the question of how oil
price changes and its volatility affect both the economy and financial markets.
Even though a number of works in the literature have studied the interactions
between oil prices and stock markets (Jones and Kaul, 1996; Sadorsky, 1999; Ciner,
2001; Basher and Sadorsky, 2006), very little attention is paid to the issue of return
and volatility spillovers (Ewing et al., 2002; Malik and Ewing, 2009) and, to the best
of our knowledge, no study has been conducted in the context of the Gulf Coopera-
tion Council (GCC) countries. By examining whether oil and GCC stock markets are
linked and how their volatility spillovers change through time and across markets
over the last turbulent decade, this paper attempts to make up for this neglect. For
this purpose, we use a recent multivariate econometric technique, Vector Autoregres-
sive Moving Average - Generalized Autoregressive Conditional Heteroskedasticity
(VAR-GARCH), introduced by Ling and McAleer (2003). One of the main advan-
tages of this model is that it allows us to investigate the conditional volatility dynam-
ics of the series as well as the conditional correlation cross effects and volatility
transmission between series. It also provides meaningful estimates of the parameters
with less computational complication compared to several other multivariate specifi-
cations such as the full factor GARCH model (Hammoudeh et al., 2009). Further, we
are able to use our findings to compute the optimal weights of an oil-stock portfolio
as well as optimal hedge ratios for analyzing hedging effectiveness. Our literature
surveys show that the VAR-GARCH model has never been employed to investigate
the relationships between oil prices and stock markets.
Using daily data over the period from June 7, 2005 to February 21, 2010 for
the six countries members of the GCC, we mainly find evidence of significant return
and volatility spillovers between oil and stock markets in the GCC region. The direct
4
transmission of conditional volatility across markets is, however, more apparent from
oil to stock segments. Empirical results from optimal weights and hedge ratios indi-
cate that investors operating in the GCC markets may benefit from adding the oil as-
sets into a well-diversified portfolio of stocks, and that hedging strategies are neces-
sary to manage the oil risk more effectively.
The remaining part of the paper is structured as follows. Section 2 provides a
short review of literature about the effects of oil price changes on the real and finan-
cial sectors. Section 3 describes the empirical methodology we use to measure shock
transmission and volatility spillover effects between oil and GCC stock markets. Sec-
tion 4 presents the data. Section 5 discusses the empirical results and shows their im-
plications on oil-risk management and portfolio optimization in presence of oil as-
sets. Concluding remarks are summarized in Section 6.
2. A short review of literature on the oil volatility effects
Previous empirical investigations including, among others, Hamilton (1983), Cunado
and Perez de Garcia (2005), and Kilian (2008) have reported that oil price shocks has
a causal link on recessions, inflation, economic growth, and other economic variables
in most developed and emerging countries, with however different degrees and
through different mechanisms. There is also empirical evidence to suggest that eco-
nomic activity and financial market returns are nonlinearly associated with oil price
changes (Hamilton, 2003; Zhang, 2008; Cologni and Manera, 2009).
The strand of research examining the potential relationships between oil price
shocks and stock markets has only gained ground very recently, and the focus is es-
5
sentially on a few net-oil importing developed countries.
1
Initially, Jones and Kaul
(1996) investigate the reaction of four developed stock markets to oil shocks on the
basis of standard cash flow dividend valuation model and find evidence of significant
impacts of oil price changes on corporate cash flows in the US and Canada. Their re-
sults were not conclusive for Japan and the UK. Subsequently, vector autoregressive
models (VAR) are often employed to explore the oil-stock market relationships, but
the results obtained are not always consistent across studies (Huang et al., 1996; Sa-
dorsky, 1999). The evidence of asymmetric and nonlinear linkages has been also do-
cumented in Sadorsky (1999) and Ciner (2001) respectively. In the context of emerg-
ing stock markets, the effect of oil shocks is generally found to be significant over
both the short and long run (Papapetrou, 2001; Basher and Sadorsky, 2006; Maghye-
reh and Al-Kandari, 2007).
However, less attention has been paid to smaller emerging markets, especially
in the GCC countries where the links between oil prices and stock markets have im-
portant implications for international investments and economic policies. First, since
GCC countries are major suppliers of oil in world energy markets, their stock mar-
kets are likely to be affected by changes in oil prices. Second, the GCC markets dif-
fer from those of developed and from other emerging countries in that they are large-
ly segmented from the international markets and are highly sensitive to regional po-
litical events. Finally, the GCC markets represent very promising areas for regional
and world portfolio diversification. A good understanding of the influence of oil
price shocks on stock markets may really assist investors for making accurate in-
vestment decisions and policymakers for regulating stock markets more effectively.

1
It should be noted that in theory oil shocks may affect stock prices through their impacts on the ma-
croeconomy and business environment which, in turn, have direct repercussions on firms expected
future cash-flows. For example, sharp oil price changes, whatever the sign, may reduce aggregate out-
put temporarily because they put back investments due to increasing uncertainties or induce costly re-
source reallocation (Guo and Kliesen, 2005).
6
The relationship between oil and stock markets in the GCC countries has been
examined by several works. For instance, Hammoudeh and Aleisa (2004) show from
VAR models and cointegration tests that there is a bidirectional relationship between
Saudi stock returns and oil prices changes. Zarour (2006) employs a VAR analysis to
study the oil-stock market links in the GCC countries and find evidence of predictive
power of oil price changes on stock market returns in Saudi and Oman. Hammoudeh
and Choi (2006) examine the long-run relationship among the GCC stock markets in
the presence of the US oil market, the S&P 500 index and the US Treasury bill rate.
They report that the T-bill rate has direct impact on these markets, while oil and S&P
500 have indirect effects. The findings of Maghyereh and Al-Kandari (2007) are
consistent with the presence of significant nonlinear impacts of oil price changes on
stock price indices in the GCC countries over the long-run. In a more recent study,
Arouri and Fouquau (2009) focus on the short-run relationships between oil prices
and GCC stock markets using a nonparametric method and show some evidence of
nonlinearities in Qatar, Oman, and UAE. Indeed, the relationships between oil prices
and stock markets in these countries are found to be asymmetric and regime-
switching with respect to the values of oil price changes. Unfortunately, the unknown
analytical form of this nonlinear link does not facilitate the use of their results in
portfolio management or policy decision-making process.
As noted in the introduction part, the issue of volatility transmission between
oil and stock markets has been relatively less explored in the extant literature, two
exceptions being Ewing et al. (2002), and Malik and Ewing (2009). Using several
univariate and multivariate time-series techniques including the multivariate BEKK-
GARCH model to examine the volatility transmission between oil and natural gas
markets, the first study finds significant direct and indirect transmission of volatility
7
from the natural gas sector to the oil sector. There is nevertheless only weak evidence
of volatility transmission from oil sector to natural gas sector. These findings are typ-
ically explained by the differences in the volatility behavior of oil and natural gas
sectors, as noted by these authors. The second study, being the most related to ours,
employs a bivariate GARCH model to evaluate the volatility transmission between
five different US sector indices and oil prices. It provides evidence of significant
spillovers of shocks and volatility between oil prices and some of equity sectors.
This present study thus brings insights about the dynamic interdependence of
world oil price and GCC stock markets in terms of both returns and conditional vola-
tility by using a VAR-GARCH approach. It further sheds light on the potential gains
of cross-market hedging as well as on the sharing of common information by market
operators.
3. Econometric method
As far as volatility modeling of oil and stock markets is concerned, GARCH-type
models have received a particular interest from almost all previous papers (e.g., Na-
rayan and Narayan, 2007; Kang et al., 2009; Oberndorfer, 2009; Choi and Hammou-
deh, 2010). It is commonly shown that multivariate volatility models such as BEKK
(full parameterization), CCC (Constant Conditional Correlation) or DCC (Dynamic
Conditional Correlation) models with dynamic covariances and conditional correla-
tions are more relevant than univariate models. These models are however subject to
a major drawback that their estimation becomes extremely difficult, especially when
the number of variables considered is important owing to the rapid proliferation of
parameters to be estimated. Additionally, they do not explicitly allow for cross-
market volatility spillover effects, while the latter are likely to occur with the increas-
8
ing integration of capital markets. These reasons lead us to choose the newly devel-
oped VAR-GARCH model to explore the joint evolution of conditional returns, vola-
tility and correlations among the oil and stock markets included in the system. Intro-
duced by Ling and McAleer (2003), this approach was applied by, among others,
Chan et al. (2005), and Hammoudeh et al. (2009) to tourism demand variations and
stock markets, and appears to provide meaningful and interpretable coefficients.
Specifically, the VAR-GARCH model described in Ling and McAleer (2003)
includes the multivariate CCC-GARCH model of Bollerslev (1990) as a special case
where correlations between system shocks are assumed to be constant to ease the es-
timation and inference procedure. In this paper, we adopt the bivariate form of this
model to investigate the interdependence of oil and stock markets in each country of
the GCC. The specification we consider is thus a bivariate VAR(1)-GARCH(1,1)
where the conditional mean is given by
2

=
+ u + =

t t t
t t t
D
Y Y


1
(1)
where
) , ( ' =
o
t
s
t t
r r Y with
s
t
r and
o
t
r being the returns on stock market and oil price
indices at time t respectively;
u is a (22) matrix of coefficients of the form
|
.
|

\
|
= u
2
1
0
0

;
) , ( ' =
o
t
s
t t
with
s
t
and
o
t
being the residual terms from the mean equa-
tions of stock market and oil returns respectively;
) , ( ' =
o
t
s
t t
refers to a (21) vector of independently and identically distri-
buted errors;

2
The optimal number of lags for the VAR system was chosen on the basis of commonly-used infor-
mation criteria.
9
and ) , (
o
t
s
t t
h h diag D = with
s
t
h and
o
t
h being the conditional variances of
s
t
r and
t
o
r respectively. Their time-series dynamics are modeled in Equations
(2) and (3) as:
2
1
2
2 1
2
2
2
1
2
1 1
2
1
2
) ( ) (
o
t s
o
t s
s
t s
s
t s s
s
t
h h C h

+ + + + = (2)
2
1
2
2 1
2
2
2
1
2
1 1
2
1
2
) ( ) (
s
t o
s
t o
o
t o
o
t o o
o
t
h h C h

+ + + + = (3)
As it can be seen, the conditional variance of the stock market (resp., oil mar-
ket) depends not only on its own pasts and innovations, but also on those of the oil
market (resp., stock market). This particular feature thus permits the direct transmis-
sion of volatility and shocks from one market to another. We can also express the
conditional covariance,
so
t
h , as follows:
o
t
s
t
so
t
h h h = (4)
where is the conditional constant correlation.
3
Taken together, the characteristics of the proposed model allow us to capture
both return and volatility spillover effects between oil and stock markets. To the ex-
tent that the normality condition is often rejected for the majority of macroeconomic
and financial series, we use the quasi-maximum likelihood (QML) method to esti-
mate the models parameters.
4
In Section 5, we will show how the estimation results
from our VAR(1)-GARCH(1,1) model can be used to compute the optimal weights
and hedge ratios of an oil-stock diversified portfolio.

3
It is worth emphasizing that the model VAR-GARCH with dynamic conditional correlations has not
been analysed theoretically yet (McAleer et al., 2009).
4
See Ling and McAleer (2003) for further details about the asymptotic properties of the VAR-
GARCH model and its estimation procedure.
10
4. Data and preliminary results
Our study examines the return and volatility linkages for the six countries members
of the GCC (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and UAE) over the period
from June 7, 2005 to February 21, 2010.
5
Stock market indices are obtained from
MSCI database, while world oil price data are extracted from the Energy Information
Administration (EIA). Note that the Brent spot prices are used to represent the inter-
national crude-oil market since they usually serve as reference prices for pricing
crude oil and many other derivatives products using oil as underlying asset. Unlike
the majority of previous studies which employ low frequency data (yearly, quarterly,
monthly, and weekly), we use daily data in order to adequately capture the rapidity
and intensity of the dynamic interactions between oil and stock prices in the GCC re-
gion. All price data are denominated in US dollars to avoid the impacts of exchange
rates and to ease the comparison across countries. Daily returns are calculated from
daily price data by taking the natural logarithm of the ratio of two successive prices.
The statistical and stochastic properties of the data are summarized in Table 1.
In Panel A, we test for the presence of unit roots in the levels and first differ-
ences of oil and stock market price indices. The results from the Augmented Dickey
Fuller (ADF) tests indicate that the price series are integrated of order one or I(1),
while the returns series are stationary. We report, in Panel B, basic statistics of log
returns series. Average daily returns on GCC stock market indices are all negative
over our sample period under the effects of the recent global financial crisis 2007-
2009, sparked by the US subprime crisis. Stock market in Bahrain realized the worst
performance (-0.121%), followed by those in the UAE and Saudi Arabia. Inversely,
oil market experienced a positive average return, which is not surprising in view of

5
The data used in the majority of previous studies predate the end of 2005, and as a result they missed
the spectacular variations that have occurred in the GCC and oil markets over the last three years.
11
the increasing trend in the price of oil over the last decade. Skewness is negative for
all stock markets, and positive for oil market. This means that extreme negative and
positive returns are likely to realize for stock and oil markets respectively. Kurtosis
coefficients are important in size and highly significant, indicating that outliers may
occur with a probability higher than that of a normal distribution. Accordingly, the
Jarque-Bera test statistics strongly reject the null hypothesis of normality for all se-
ries.
Table 1
Descriptive statistics
Panel A: Augmented Dickey-Fuller (ADF) stationarity tests
Levels First difference
Bahrain -2.536
**
(a) -32.621
***
(c)
Kuwait -1.703 (b) -32.891
***
(a)
Oman -0.323 (a) -31.399
***
(a)
Saudi Arabia -0.776 (a) -33.879
***
(a)
UAE -1.231 (a) -31.186
***
(a)
Qatar -1.434 (a) -32.689
***
(a)
Oil -1.916 (c) -35.222
***
(a)
Panel B: Basic statistics of return series
Bahrain Kuwait Oman
Saudi
Arabia
UAE Qatar Oil
Mean (%) -0.121 -0.002 -0.015 -0.043 -0.081 -0.022 0.037
Max. (%) 11.502 8.752 10.750 16.226 18.326 11.258 16.413
Min. (%) -17.983 -14.871 -17.644 -21.570 -15.497 -13.171 -12.826
Std. dev 1.588 1.783 1.634 2.244 2.207 2.008 2.768
Skewness -1.978 -1.249 -1.479 -1.508 -0.754 -0.563 0.104
Kurtosis 27.293 14.262 24.017 18.291 14.499 10.261 7.394
Jarque-Bera 30519
***
6704
***
22692
***
12238
***
6776
***
2707
***
975
***
ARCH(20) 64.2
***
40.1
***
76.7
***
39.6
***
35.7
**
38.4
***
59.1
***
Correlation
with Brent oil
0.061 0.018 0.026 0.024 0.10 0.373 -
Notes: ADF test is carried out using log prices and returns series. (a) designates a model with neither
constant nor deterministic trend; (b) a model with constant and without deterministic trend; and (c)
model with constant and deterministic trend.
*
,
**
and
***
denote rejection of the null hypothesis re-
spectively at the 10%, 5% and 1% levels, respectively.
As also shown in Panel B, all the return series were found to have a leptokurtic
behavior (i.e., their distributions have fatter tails than corresponding normal distribu-
tions). This suggests that each of the mean equations should be tested for the exis-
tence of conditional heteroscedasticity. By applying the Engle (1982)s test, we ob-
serve that the null hypothesis of ARCH effects cannot be rejected at conventional le-
12
vels in all cases, thus confirming that GARCH modeling is adequate for capturing
any persistence in the financial volatility of stock and oil markets we consider.
We also compute the unconditional correlations between GCC stock market re-
turns and oil price changes. The results reveal that cross-market correlations are not
high, but on average positive. These correlations range from 0.018 (Kuwait-Brent) to
0.373 (Qatar-Brent). This finding indicates that the presence of oil asset in a portfolio
may lead to greater diversification benefits.
5. Empirical results and portfolio implications
In what follows, we will first discuss our findings related to return linkages and vola-
tility transmission between oil and stock markets in the GCC countries within the
empirical framework of the VAR(1)-GARCH(1,1) model. Recall that the appropriate
lag length for the VAR system was determined by the usual information criteria (BIC
and SIC). We will then use the estimation results to compute the optimal weights of
an oil-stock portfolio as well as the optimal hedge ratios.
5.1 Return and volatility dependencies
Our VAR(1)-GARCH(1,1) estimation results are reported in Tables 2-7 for the six
oil-stock market pairs. Regarding the interdependence of returns in mean equations,
we find that lagged oil price returns significantly affect stock market returns in three
out of six cases: Bahrain, Oman, and Qatar. The effect of oil on stock markets is pos-
itive for Oman and Qatar, but negative for Bahrain. Inversely, oil returns are only
significantly related to stock market returns in Bahrain, but the link is negative. The
lagged value of stock market returns is found to be significant in two stock markets
(Bahrain and Qatar), indicating that their returns are predicted from past realizations,
and thus they are not informationally efficient according to the weak-form efficiency
13
(Fama, 1991). Taken together, our findings suggest some evidence of predictability
in the dynamic variations of stock market returns with respect to previous returns on
oil and stock market indices for three GCC countries, Bahrain, Oman and Qatar.
Table 2
Estimates of VAR(1)-GARCH(1,1) for Bahrain
Variables Bahrain Oil
Mean equation
C
Bahrain(1)
Oil(1)
0.7387
***
(0.1209)
0.1743
**
(0.0708)
-0.1914
***
(0.0432)
0.2989
**
(0.1212)
-0.2359
***
(0.0863)
0.0781
*
(0.0457)
Variance equation
C
2
1
) (
s
t

2
1
) (
o
t

s
t
h
1
o
t
h
1
-0.077 (9.7740)
-0.0025 (3.3908)
-0.0373 (0.2574)
-0.9411
***
(0.1179)
0.2772 (0.2907)
0.2979 (0.2326)
-0.0019 (5.0112)
0.1752
***
(0.0404)
0.2830 (0.3308)
0.9567
***
(0.0710)
Constant conditional correlation
Bahrain
Oil
1.0000
0.1918
***
(0.0557) 1.0000
Log likelihood
AIC
SIC
-5253.606
8.7697
8.8417
Notes: The optimal lag order for the VAR model is selected using the SIC information criterion. Stan-
dard errors are given in parenthesis.
*
,
**
and
***
denote rejection of the null hypothesis at the 10%, 5%
and 1% levels, respectively.
As for the estimates of ARCH and GARCH coefficients in the conditional va-
riance equations, they are significant at conventional levels in most cases. The sensi-
tivity to past own conditional volatility (GARCH-term) appears to be significant for
all countries, except for Qatar. This finding typically suggests that past values of the
conditional volatility in a particular stock market can be employed to forecast future
volatility. The results also show that the current conditional volatility of GCC stock
markets also depends on past shocks affecting return dynamics since ARCH-terms
are highly significant for all countries considered, with an exception for Bahrain.
14
Figure 1. Time-variations of conditional volatility for GCC stock markets
A closer inspection of the above coefficients reveals that in general conditional
volatility does not change very rapidly as the ARCH-terms measuring the impact of
past shocks on conditional volatility are relatively small in size. On the other hand,
the GARCH-terms, which capture the impact of past volatility on current volatility,
are substantially large, indicating gradual fluctuations over time. These properties
can be further apprehended through Figure 1 where we plot the time-variations of
conditional volatility for the six stock markets under investigation. It should be final-
ly noted that the similar conclusions hold for oil price volatility.
15
Table 3
Estimates of VAR-GARCH for Kuwait
Variables Kuwait Oil
Mean equation
C
Kuwait(1)
Oil(1)
0.0374 (0.0518)
0.0511 (0.0368)
-0.0096 (0.0257)
0.1390
**
(0.0549)
-0.0359 (0.0437)
-0.0322 (0.0252)
Variance equation
C
2
1
) (
s
t

2
1
) (
o
t

s
t
h
1
o
t
h
1
-0.0004 (26.2900)
-0.0881
***
(0.0304)
-0.0144 (0.1989)
0.9519
***
(0.0242)
0.2180
***
(0.0682)
0.1605 (0.1086)
-0.0925
*
(0.0557)
0.2033
***
(0.0235)
0.2576
*
(0.1502)
0.9538
***
(0.0259)
Constant conditional correlation
Kuwait
Oil
1.0000
0.0685
**
(0.0283) 1.0000
Log likelihood
AIC
SIC
-4904.386
8.1886
8.2606
Notes: The optimal lag order for the VAR model is selected using the SIC information criterion.
Standard errors are given in parenthesis.
*
,
**
and
***
denote rejection of the null hypothesis at the
10%, 5% and 1% levels, respectively.
Turning out to the volatility spillover effects between oil and stock markets in
the GCC countries, we first observe that there is no direct transmission of volatility
from oil market to Bahraini and Qatari stock markets (Tables 2 and 5). For the four
remaining countries (Tables 3-4 and 6-7), the cross-volatility coefficients (return in-
novation and volatility) are significant at conventional levels. More precisely, past oil
shocks have significant effects on stock market volatility in Saudi Arabia, while past
oil volatility strongly affects stock market volatility in Kuwait, Oman and the UAE.
However, the effects of past shocks and past volatility of oil returns on volatility of
stock markets in GCC countries should be moderated since their estimated coeffi-
cients are much smaller than those of past own shocks and volatilities. Oil price vola-
tility is affected, on the one hand, by past market shocks in Kuwait, and on the other
hand by past stock market volatility in Oman and the UAE. Therefore, direct volatili-
ty spillover is more widespread from oil to stock markets in the GCC countries than
16
the inverse case. Investors should then keep a close watch on what is going on in the
oil market in order to make accurate investment decisions.
Table 4
Estimates of VAR-GARCH for Oman
Variables Oman Oil
Mean equation
C
Oman(1)
Oil(1)
0.0021 (0.0809)
0.0700 (0.074)
0.0959
***
(0.0348)
0.0522 (0.0830)
0.0104 (0.0687)
0.0067 (0.0358)
Variance equation
C
2
1
) (
s
t

2
1
) (
o
t

s
t
h
1
o
t
h
1
0.2360 (0.1450)
-0.3730
***
(0.0635)
0.0022 (3.0922)
0.9052
***
(0.0334)
0.2458
***
(0.0784)
0.3226
***
(0.0893)
-0.0265 (0.8341)
0.2252
***
(0.0317)
0.2350
*
(0.1346)
0.9551
***
(0.0180)
Constant conditional correlation
Bahrain
Oil
1.0000
0.3163
***
(0.0425) 1.0000
Log likelihood
AIC
SIC
-4878.672
8.1458
8.2178
Notes: The optimal lag order for the VAR model is selected using the SIC information criterion.
Standard errors are given in parenthesis.
*
,
**
and
***
denote rejection of the null hypothesis at the
10%, 5% and 1% levels respectively.
Table 5
Estimates of VAR-GARCH for Qatar
Variables Qatar Oil
Mean equation
C
Qatar(1)
Oil(1)
-0.0529 (0.3190)
0.2127
**
(0.0913)
0.2006
*
(0.1141)
0.2257 (0.2425)
0.0930 (0.0789)
0.3115
***
(0.0865)
Variance equation
C
2
1
) (
s
t

2
1
) (
o
t

s
t
h
1
o
t
h
1
2.5835 (7.3489)
0.4966
***
(0.1585)
-0.0447 (1.3988)
0.4950 (0.4584)
0.0662 (360.250)
2.4520 (7.6177)
-0.1189 (0.2522)
0.0088 (6.2466)
-0.2344 (1.0028)
0.4814 (4.9435)
Constant conditional correlation
Qatar
Oil
1.0000
0.2804
***
(0.0871) 1.0000
Log likelihood
AIC
SIC
-865.8705
10.4481
10.7630
Notes: The optimal lag order for the VAR model is selected using the SIC information criterion.
Standard errors are given in parenthesis.
*
,
**
and
***
denote rejection of the null hypothesis at the
10%, 5% and 1% levels, respectively.
17
Table 6
Estimates of VAR-GARCH for Saudi
Variables Saudi Arabia Oil
Mean equation
C
Saudi(1)
Oil(1)
0.0506 (0.0511)
-0.0125 (0.0433)
0.0297 (0.0259)
0.1328
**
(0.0585)
-0.0180 (0.0310)
-0.0238 (0.0296)
Variance equation
C
2
1
) (
s
t

2
1
) (
o
t

s
t
h
1
o
t
h
1
0.1434
***
(0.0365)
0.2895
***
(0.0163)
-0.0894
***
(0.0219)
0.9580
***
(0.0046)
-0.0006 (4.6107)
-0.3103
***
(0.0685)
0.0262 (0.1145)
0.2909
***
(0.0213)
0.0004 (8.2154)
0.9485
***
(0.0085)
Constant conditional correlation
Saudi
Oil
1.0000
0.0628
**
(0.0288) 1.0000
Log likelihood
AIC
SIC
-5192.234
8.6676
8.6947
Notes: The optimal lag order for the VAR model is selected using the SIC information criterion.
Standard errors are given in parenthesis.
*
,
**
and
***
denote rejection of the null hypothesis at the
10%, 5% and 1% levels, respectively.
Table 7
Estimates of VAR-GARCH for UAE
Variables UAE Oil
Mean equation
C
UAE(1)
Oil(1)
-0.1629 (0.1040)
0.0651 (0.0459)
0.0323 (0.0404)
0.1113
*
(0.0661)
0.0501 (0.0375)
0.0127 (0.0283)
Variance equation
C
2
1
) (
s
t

2
1
) (
o
t

s
t
h
1
o
t
h
1
0.3593
***
(0.1123)
0.2057
***
(0.0226)
-0.0030 (2.5591)
0.9456
***
(0.0230)
0.2548
**
(0.0992)
0.2577
*
(0.1396)
0.0005 (10.8785)
0.2193
***
(0.0273)
0.2176
**
(0.1011)
0.9421
***
(0.0238)
Constant conditional correlation
UAE
Oil
1.0000
0.1155
***
(0.0370) 1.0000
Log likelihood
AIC
SIC
-5292.651
8.8346
8.9067
Notes: The optimal lag order for the VAR model is selected using the SIC information criterion.
Standard errors are given in parenthesis.
*
,
**
and
***
denote rejection of the null hypothesis at the
10%, 5% and 1% levels, respectively.
As expected, the estimates for constant conditional correlations between oil
and stock markets in the GCC countries are all positive. They are small in general,
18
suggesting the existence of potential gains from investing in both stock markets and
oil.
Summarizing all, the empirical VAR(1)-GARCH(1,1) model appears to satis-
factorily capture the return linkages and volatility transmission for the six pairs of
markets we consider. Stock market returns are significantly influenced by oil returns
in three out of six cases, and they only affect oil returns in Bahrain. The analysis of
volatility interdependence shows significant volatility spillovers from oil to stock
markets, while oil volatility is sensitive to stock market volatility in only two coun-
tries.
5.2 Portfolio management with oil-risk hedging strategies
Our previous findings suggest that potential gains from diversification are substantial
by investing in both oil and stock markets. Their return and volatility spillovers re-
quire however portfolio managers to quantify the optimal weights and hedging ratios
in order to deal adequately with the oil risk. To illustrate this purpose, we now con-
sider a portfolio composed of oil and stocks for which we attempt to minimize the
risk without reducing expected returns. According to Kroner and Ng (1998), the op-
timal weight of holdings of the two assets (oil and the stock market index) is given
by:
s
t
os
t
o
t
os
t
s
t
t os
h h h
h h
w
+

=
2
,
(5)
and,

>
s s
<
=
1 , 1
1 0 ,
0 , 0
,
, ,
,
,
t os
t os t os
t os
t os
w if
w if w
w if
w (6)
where
t os
w
,
refers to the weight of oil in a one-dollar tow-asset portfolio at time t;
and
os
t
h the conditional covariance between oil and stock market returns at time t.
19
Therefore, the optimal weight of the stock market index in the considered portfolio is
t os
w
,
1 .
Table 8
Weights and hedge ratios
Bahrain Kuwait Oman Saudi UAE Qatar
t os
w
,
0.6172 0.6534 0.7028 0.5778 0.4686 0.3997
t os,

0.2328 0.0924 0.4289 0.0782 0.1099 0.2430

Notes: The table reports average optimal weights and hedge ratios in an oil-stock market portfolio.
The average values of
t so
w
,
(optimal weights) for the six GCC countries are
reported in Table 8. They vary from 39.97% for Qatar to 70.28% for Oman. This
suggests that for the Qatari case the optimal holding of oil in a one-dollar oil-stock
market portfolio should be 39.97%, and the remaining budget of 60.03% is invested
in stock market. For the Omani case, these optimal investment weights are 70.28%
and 29.72% respectively. Overall, our results point to the fact that except for Qatar
and the UAE, investors holding assets in the GCC countries should have more oil
than stocks in their portfolios in order to minimize the risk without lowering the ex-
pected return.
As for hedge ratios, Kroner and Suktan (1993) consider a portfolio of two as-
sets (oil and market stock index in our case). To minimize the risk of this portfolio, a
long position of one dollar in the oil market should be hedged by a short position of
t
dollars in the stock market index, that is:
s
t
os
t
t os
h
h
=
,
(7)
Table 8 reports average values of the hedge ratios computed by using Equation
(7) over the estimation period. As we can see, these ratios are low in general suggest-
ing that hedging effectiveness involving oil and stock markets in the GCC countries
20
is quite good, as compared to that in other developed markets (e.g., Hassan and Ma-
lik, 2007). They range from 0.0782 in Saudi Arabia to 0.4289 in Oman. Accordingly,
one dollar long in oil should be shorted by about 8% and 42% of stocks in Saudi
Arabia and Oman respectively. Our results are thus consistent with the view that in-
clusion of oil into a diversified portfolio of stocks increases the risk-adjusted perfor-
mance of the resulting portfolio.
6. Concluding remarks
This paper investigates the return informational linkages and volatility transmission
between oil and stock markets of the GCC countries over the last turbulent decade.
We employ a VAR-GARCH approach which allows for spillover effects in both re-
turns and conditional volatilities. We also analyze the optimal weights and hedge ra-
tios for oil-stock portfolio holdings. Overall, our results point to the existence of sig-
nificant volatility spillovers between oil and stock markets in three out of six GCC
countries, with the volatility transmission being more apparent from oil to stock mar-
kets. For these markets, the rise in oil price volatility caused by shocks and policy
changes affecting oil supply- and demand-side would directly increase their volatili-
ty. They further suggest that adding the oil assets into a well-diversified portfolio of
stocks issued by GCC markets leads to improve its overall risk-adjusted return per-
formance and that oil price risk can be hedged more effectively in the GCC context.
The findings of the study offer several avenues for future research. First, the
link between oil and stock markets in GCC countries can be expected to vary across
different economic sectors. A sector analysis of this link would be more informative
and generate more accurate implications for portfolio management. Second, further
evidence drawn from international equity markets should be produced to examine the
21
robustness of the findings. Third, the methodology applied in this article could be
used to investigate the effects of other energy products such as natural gas on aggre-
gate and sector equity returns. Finally, further research on the oil-stock return and
volatility linkages could compare their causality across GCC countries and other oil-
exporting as well as oil-importing countries.
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