Oil Price Shocks and Stock Market Performance in the BRICs: Some Evidence using FAVAR Models

Abstract

This paper examines the response of real stock prices to oil price shocks for four selected emerging economies over the period from January 1991–March 2011. To overcome the problem of omitted information in small-scale vector autoregression (VAR) models, the factor augmented vector autoregressive (FAVAR) approach proposed by Bernanke et al (2005) is utilised. In addition, Stock and Watson (2002b) has been followed in order to extract two factors that are significantly related to a large set of world-level and country-specific macroeconomic variables. The extracted factors are then used as regressors in recursive VARs to assess the response of stock prices to oil price shocks. The key results suggest that the response of stock prices to oil price shocks is quite persistent and precise, but asymmetric across the four economies. Specifically, we observe that stock prices in Brazil and India respond negatively to oil price shocks, whereas the response in China is positive. We also observe that stock prices in Russia initially respond positively, however, the response becomes negative after four months. The impulse-response results indicate that the impact of oil price shocks on stock prices is smaller for China than for the remaining three countries. Overall, our results suggest that the use of the FAVAR approach allows us to obtain more coherent evidence on the effects of oil price shocks on stock prices, by obtaining relatively more precise responses and thus increasing understanding of such shocks from a theoretical point of view.