The connectedness between crude oil and financial markets: Evidence from implied volatility indices

Abstract

In this paper we exploit newly introduced implied volatility indexes to investigate the directional risk transfer from oil to US equities, Euro/Dollar exchange rates, precious metals and agricultural commodities. We find significant volatility transmission from oil to equities but little transmission to agricultural commodities. The total pairwise directional connectedness to equities is around 20.4%, while it is only 1.6%, 1.0% and 2.0% to wheat, corn, and soybeans respectively. The risk spillover from oil to precious metals and Euro/Dollar foreign exchange rates is moderate. For instance, the oil market uncertainty spills 11.0%, 11.1% and 8.9% to gold, silver and Euro/Dollar exchange rate respectively. The volatility crossover from all of these markets to oil is tiny, implying that oil is the main driver of its association with these markets. Finally, we provide evidence that the transmission from oil to other markets has increased since the collapse of oil prices in July 2014. IntroductionRecently, a number of papers have studied the co-movement of oil with equities, agricultural commodities and precious metals. Prior studies provide evidence on the connectedness between oil and one or more markets. However, the bulk of these studies have so far focused on price connectedness. Little research has been dedicated to volatility association. Like prices, volatilities are important driving factors of options markets. This raises an interesting question: how are oil and other related markets associated in terms volatilities? The main aim of this paper is to provide an answer to such a question.Most of the existing studies on oil connectedness have investigated the relation between the oil market and other markets on a one-to-one basis. 1 In contrast, this study looks into the oil association using all relevant markets. Specifically, we study the influence of oil on the US equity market, the Euro/Dollar exchange rate market, the gold market, the silver market, the wheat market, the corn market and the soybeans market.One notable exception is Sari et al. (2010) who studied oil association with more than one market. However, we take a more inclusive approach as we consider a broader set of markets in the analysis. Our choice of markets represents a universe of financial assets that cover a wide range of investment strategies. The cash and derivative markets associated with these assets are global, large and liquid and therefore the risk transfer between oil and these markets is an important piece of information for investors.cross Many hedge funds have their strategies and asset classes defined within the context of these markets. For instance, global macro funds take opportunities in cash and derivatives markets that include equities, currencies and commodities. Similarly, managed futures funds invest in futures and options that are written on the commodities traded in these markets. The exposure to these markets is usually assumed indirectly through derivatives and hence, the study of risk connectedness between oil a...

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