A Study on the Spillover Effect between
Foreign Exchange market and Oil market

by Heo, Giyeong

Department of Business Administration
Graduate School of Changwon National University
Changwon, Korea


The price of petroleum or oil has kept rising since the middle of 2000s once soaring to 145$/barrel. Recently, however, the price nose dived probably due to both the increase in supply-side from the preemptive action of oil producing countries against shale gas production, and the decrease in the demand side from the 2008 financial crisis. In short, current world oil markets are as uncertain as ever.
Despite this uncertainty growing circumstance of oil markets, most of the literature, at best, address the effect of dollar on oil price in oil markets or the effect of U.S. dollar in exchange market on WTI oil market. To my best knowledge, literature on spillover effect among the world''s big 3 oil markets, namely, WTI, Brent and Dubai is hard to find.
From this perspective, this paper aims to investigate the relationship between exchange market and the volatility of oil markets using the effective exchange rate of U.S. dollar weighted by the amount traded all over the world and to examine the volatility spillover effect between oil markets. This paper also examines the coupling phenomenon among oil markets during the whole study period and during the period after the 2008 financial crisis.
For this empirical analysis, this paper uses oil spot price indexes of WTI, Dubai, and Brent, and as exchange rate data, it uses daily effective exchange rates of U.S. dollar from February 11, 2002 to March 27, 2014. It employs DCC-GARCH model and spillover index as its methodology.
The results of this empirical analysis are as follows:
First, cointegration relation appears to be present among WTI, Dubai, and Brent oil markets. However, cointegration relation does not exist between effective exchange rates of U.S. dollar and each of these oil markets.
Second, only WTI oil market proves to be restored to normal condition or equilibrium. According to the results of the analysis with VEC model, all the oil markets are affected by past markets of 1-4 days before. That is, WTI oil market is affected by both its past market and Dubai oil market. Dubai oil market is influenced by both its past market and the past markets of WTI and Brent. Brent oil market is affected by its past market and the past market of WTI. Furthermore, WTI oil market appears to lead the markets since it is the fastest in returning to equilibrium among three markets. Dubai oil market appears to be affected more by WTI and Brent oil markets than these markets are affected by each other.
Third, the result of DCC-GARCH model shows that before the financial crisis, a negative dynamic conditional correlation exists between U.S. dollar market and oil markets, but that after the crisis, a positive dynamic conditional correlation exists between dollar exchange market and oil markets. More specifically, a negative dynamic conditional correlation witnessed before the financial crisis means that while the volatility of one market is big, it is small in the other market. On the contrary, a positive dynamic conditional correlation witnessed after the crisis means that if the volatility of one market is big, it is also big in the other market with the same sign.
And finally, according to the results of the analysis on spillover index during the 2008 financial crisis, the volatility spillover effects between oil markets are not much different from those of non crisis periods such as before and after the crisis(0.918%), while the effect of WTI on the other markets decreases by 6.735%. However, the effect of effective exchange rate of U.S. dollar on oil markets increases considerably during the crisis compared to the whole period(with the effect of 9.113% on WTI, 9.606% on Dubai, and 10.501% on Brent).
These results can have some implications that if a financial crisis takes place, the volatility of the exchange market becomes big, which can have spillover effect on the oil market resulting in a big challenge to a nation''s economy.