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Eqs. 1 and 2 show that stock returns are impacted by factors that can alter the expected cash flows and/or the discount rate, including oil prices. Oil price changes can alter a firm’s future cash flows either positively or negatively, depending on whether the firm is an oil-user (oil-consumer) or oil-producer (see Oberndorfer, 2009; Mohanty and Nandha, 2011). For an oil-consuming firm, oil is one of the major production factors and consequently an increase in oil prices will result in an increase of production costs (assuming that there are no perfect substitution effects between production factors, see Basher and Sadorsky, 2006), which, in turn, will reduce profit levels and thus future cash flows (Bohi 1991; Mork, Olsen, and Mysen 1994; Hampton, 1995; Brown and Yucel 1999; Filis et al., 2011). On the other hand, for an oil-producer the oil price increase will result in increased profit margins and thus increased expected cash flows. Intuitively, we expect oil-users to exhibit bearish behaviour during periods of oil price increase, whereas the reverse holds true for oil-producing firms.


2.2 Monetary channel

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Oil price changes also affect the expected discount rates of future cash flows (see Eq. 2). According to Mohanty and Nandha (2011), the discount rate is at least partially composed of expected inflation and expected real interest rates. Thus, the second transmission mechanism by which oil price changes impact stock returns is through inflation and interest rates.


As mentioned in Section 2.1, rising oil prices result in increased production costs. However, these costs will be transferred to consumers, leading to higher retail prices and thus higher expected inflation (see Abel and Bernanke 2001; Hamilton 1996, 1988; Barro 1984, among others). Assuming that a central




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bank follows some type of rule2, we expect monetary policy makers to increase short-term interest rates in response to higher inflationary pressures (Basher and Sadorsky, 2006).


There are two main effects of the increased short-term interest rates on stock markets. First, increases in short-term interest rates lead to an increase in commercial borrowing rates (i.e., discount rates) for any future firm investments, raising the borrowing costs of firms. Furthermore, the increased borrowing costs lead to fewer positive net present value (NPV) projects (lower cash flows). Thus, either due to increased discount rates and/or lower cash flows, stock prices decrease in value.


We should highlight here that the magnitude of the aforementioned effects depends on the central bank’s credibility to stabilize inflation. Assuming a highly credible central bank, we maintain that inflation expectations will remain stable, despite an oil price increase, and thus close to the inflation target. Through this expectations channel, we do not expect a significant increase in inflation following an oil price increase. By contrast, in the case of a low credibility central bank, inflation expectations will be volatile and this results in a larger change of inflation expectation, following an oil price increase, leading to an even worse impact on stock price levels.


2.3. Output channel


The third channel is the output channel. The literature maintains that oil price fluctuations affect aggregate output (see, inter alia, Hamilton, 1983; Hamilton, 2003; Kilian, 2008a, 2008b; Hamilton, 2009a). According to this channel, positive oil price changes are expected to have both an income and a production cost effect, which will lead to changes in aggregate output. The production cost effect was explained in Section 2.1, so we will concentrate on the income effect in this section.


More specifically, increased oil prices tend to lead to lower the discretionary income of households, due to the changes in retail prices (as a result of increased production costs), but also due to the increased prices of gasoline and heating oil (Bernanke, 2006; Edelstein and Kilian, 2009). Lower income leads to lower consumption and thus aggregate output, which further leads to lower labour demand. Put differently, an increase in oil prices will worsen the terms-of-trade for an oil-importing economy, which will result in lower income and a negative wealth effect on consumption, and in turn to lower aggregate demand (Svensson, 2005 and 2006). Stock markets tend to respond negatively to such developments. We maintain that this will be the response of stock markets, based on Eqs. 1 and 2. In particular, lower aggregate demand leads to lower expected cash flows for firms, which further leads to lower stock prices.



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