Elsevier

Energy Economics

Volume 66, August 2017, Pages 559-570
Energy Economics

Can stock market investors hedge energy risk? Evidence from Asia

https://doi.org/10.1016/j.eneco.2016.11.026Get rights and content

Highlights

  • The relation between energy and stock prices is investigated in the context of Asia.

  • There is time-varying integration between individual stock markets and the energy portfolio.

  • This relation can successfully hedge the common factor arising from energy risk.

Abstract

​The relationship between energy and stock prices is investigated in the context of Asia, including China and Japan. Oil, gas and coal prices are considered both individually and as an energy portfolio. Consistent with evidence from international markets, during the post Global Financial Crisis (GFC) period, Asian stock markets moved in tandem with oil prices. However, using asset pricing and portfolio theory, we identify a time-varying integration between individual stock markets and the energy portfolio, which in turn may limit the benefit of risk reduction through diversification. This relation can also be used to hedge the common factor arising from energy risk. Doing so provides benefits to investors in the form of positive time-varying risk adjusted returns.

Introduction

The short and long term relationship between oil and stock prices and its economic implication for financial market participants remains a perennial concern. Of note is the recent positive co-movement between energy and commodity prices more generally (e.g. De Nicola et al., 2016, Balcilar et al., 2017), as well as the lead–lag relationship, or volatility spillovers, between energy prices and developed country stock markets (e.g. Mensi et al., 2013, Demirer et al., 2015b, Kyrtsou et al., 2016, Balcilar et al., 2017). While much of the recent literature explores those common factors that may link these two assets, such as aggregate demand and risk (e.g. Bernanke, 2016)1, others focus on the macroeconomic impacts of energy price shocks. This includes the impact on output and inflation in energy dependent economics such as China (e.g. Zhao et al., 2016), as well as the broader impact of transitory (e.g. changes in interest rates) and permanent (e.g. changes in technology such as the introduction of hydraulic fracking) shocks on energy and stock prices. These shocks add significantly to economic policy uncertainty worldwide, not just for energy exporting, or importing, countries (e.g. Kang and Ratti, 2013, Aloui et al., 2016; and Guo et al., 2016). Despite this extensive literature, there are relatively few recent studies that offer insights into how co-movement in the oil–stock price relationship in a portfolio setting, can be utilized to hedge, or offset, the risk of one asset against the other. What is clear, is the importance of considering how oil and stock price comovements differ in the short and long term (Balcilar et al., 2017).

We contribute to a portfolio literature investigating the energy-stock price nexus that includes recent papers by Ghorbel and Trabelsi (2014) and Pan et al. (2016), who begin by considering several energy commodities in a portfolio context, while addressing the dynamic correlation structure (e.g. Balcılar et al., 2016). However, in the spirit of Sadorsky (2014), Khalfaoui et al. (2015) and Basher and Sadorsky (2016) amongst others, who examine the hedging implications arising from the relation between oil prices and developed country stock markets, in this paper, we take an Asian perspective, although the approach adopted can be applied more widely. Asia's financial markets are well-known for being highly integrated despite variation in the level of economic development (e.g. Park, 2013).

The novelty of our approach is that the relation between energy and stocks is investigated in the context of the international capital asset pricing theory of Solnik (1977) and Stulz (1981), and builds upon recent work, applying these theories to portfolios containing commodities (e.g. Asmar and Brahmana, 2012, Batten et al., 2015b, Bekiros et al., 2016; and Fernandez-Perez et al., 2016). Doing so offers the possibility of establishing the degree of financial market integration between these markets, where integration is measured in the sense of Bekaert and Harvey, 1997, Bekaert and Harvey, 2000, as well as Gérard et al. (2003). This approach also allows the determination of whether the degree of integration can be used to hedge the sensitivity of a regional stock portfolio to international market factors. Our approach, by virtue of its ability to measure time-varying sensitivities, differs from other studies that employ cointegration-based or Error Correction Models (ECM), such as D'Ecclesia et al. (2014), Bondia et al. (2016) and Ghosh and Kanjilal (2016), amongst others.

This study importantly contributes to recent work investigating the link between energy and stock prices, although our energy portfolio approach expands upon those studies that focus purely on the link between stock markets and oil prices (e.g. Chen et al., 2010, Aloui et al., 2012, Mensi et al., 2013, Martin-Barragan et al., 2015; Salisu and Oloko, 2015, Balcilar et al., 2017), or from a regional or country perspective (e.g. Arouri and Rault's (2012) and Jouini and Harrathi's (2014) analysis of the Gulf region, Moya-Martinez et al.'s (2014) analysis of Spain, or Mensi et al.'s (2015) analysis of Saudi Arabia). When energy portfolio risk is decomposed into its individual components, coal and gas offer better hedging possibilities for the Asian region than oil. This result is not surprising given the dependence on the region for coal as an energy fuel. This finding adds to Sadorsky (2014), who did not consider other energy alternatives, and found that the oil price, on average, provided an effective hedge for emerging stock prices.

It is now well known that as developed economies have become more economically and financially integrated with world markets due to factors such as freer trade, less restrictive capital flows and deregulation, the benefits from the international diversification of stock markets have also been reduced (e.g. Christoffersen et al., 2012, Avdulaj and Barunik, 2015, Khalfaoui et al., 2015). Nonetheless, additional diversification benefits may be achieved through investment in commodities, especially precious metals, which increasingly are being treated as financial assets (e.g. Kolodziej et al. (2014) for the case of oil). While significant diversification benefits may only arise when markets are segmented, enhanced market integration facilitates the use of one asset to hedge another. Thus, if Asian stock markets have indeed become more financially integrated (as suggested by Aityan et al. (2010), Wong and Fong (2011) and Batten et al. (2015a), as well as with commodities, then these commodity portfolios may be used to hedge residual systematic risk inherent in an international asset portfolio, or realize better risk diversification (e.g. Hammoudeh et al., 2014, Sarafrazi et al., 2014).

Given that a stock market in the Asian region is fully integrated with either a specific energy commodity, or an energy portfolio, idiosyncratic risk is fully diversifiable and its associated price is zero. While the individual stock markets may not be fully integrated with the world market, we simplify our analysis by assuming that a single world price of risk exists for the energy commodities investigated. This is a reasonable assumption given that while energy commodities trade in various markets worldwide, they are priced in a common currency, namely the United States (US) dollar. This is certainly the case historically with oil and coal prices, and increasingly so with natural gas contracts, with imports now shifting to short-term contracts based on spot market prices (EIA, 2016).

The results show that benefits accrue to Asian investors from investment in energy commodities both individually and in a portfolio. The difficulty is that individually, as well as bundled into a portfolio, these energy commodities possess varying degrees of integration with regional stock markets. We also show that under certain circumstances, investors may benefit from positive pricing errors (excess risk adjusted returns) in some energy markets. These benefits should motivate regional investors to hold energy assets as part of an international portfolio. However, these pricing errors are also time-varying and are affected by crises. The time-varying nature of the benefits that arise from diversification and their breakdown during periods of crisis, highlights the problems that investors face when using energy assets as a long term investment class in addition to traditional holdings of stocks and bonds. Temporal instability in the underlying correlation structure also requires constant portfolio rebalancing to avoid losses. These findings remain despite several robustness tests including varying the exact types of energy asset (e.g. different measures of the oil price).

These results add to an existing body of work both in asset pricing and financial market integration, as well as providing new insights to the examination of the relation between energy and financial assets, in this case stock markets. As such the paper adds to those recent studies that suggest energy assets now play an important role in financial portfolios in addition to varying the composition of stocks and bonds (e.g. Mongars and Marchal-Dombrat, 2006). While Bernanke (2016) notes that recently energy and stock prices have co-moved, we show later that this was not the case in the years prior to the GFC for the Asian region. This highlights the episodic ability of energy assets to hedge systematic risk in an Asian stock portfolio.

The paper is structured as follows: in the following Section 2, a brief overview of the literature is provided; then in 3 Data, 4 Method the data and asset pricing modeling are explained; the results are then presented including robustness checks; the final section allows for conclusions.

Section snippets

Literature

The broader context of this study is the effect of economic and financial market integration on the ability of economic agents to secure risk–return benefits from the diversification of asset portfolios. Specifically, as developed economies have become more economically linked through free trade agreements and other economic relationships (e.g. Hong and Yang, 2011), and financially integrated (e.g. deregulation) with world financial markets, the benefits that would accrue to investors from

Data

The approach adopted is to firstly measure energy price movements in US dollars both individually and in a portfolio from January 1990 to December 2015. This portfolio comprises the three primary sources of energy: coal, natural gas and oil. The three energy commodities used in this study comprise the following:

  • 1.

    Oil. Average of Dated Brent, West Texas Intermediate, and the Dubai Fateh, US Dollars per Barrel (source: The World Bank). West Texas Intermediate is very highly correlated to other

Method

We are motivated to undertake modeling in an asset pricing context, rather than a cointegration framework, due to the conflicting findings reported earlier using basic cointegration and correlation tests. The asset pricing framework also provides additional insights from a portfolio perspective and highlights any benefits that may arise for diversification and hedging. The degree of integration is determined using an International Capital Asset Pricing Model (ICAPM), where the beta is

Results

The results from the estimation of Models (2) and (3) above are reported in the following tables and figures. The first, Table 2 reports the properties of the βi coefficient from Model (2) for various stock and energy portfolio combinations. Fig. 2 also plots the results from an Analysis of Means with the results averaged on an annual basis. Table 3 will then describe the integration statistics associated with Model (2), while Table 5 will provide the results from Model (3).

The descriptive

Additional robustness tests

A number of robustness tests were undertaken with respect to estimation of the integration Model (2). The first test was estimation using individual oil prices (such as West Texas Intermediate) instead of the average of all three prices; and (b) the substituting of Australian thermal coal with South Africa coal. In both cases the integration results did not change significantly due to the high correlation between the alternate prices. For brevity these results are not reported in additional

Conclusions

We use an asset pricing framework to show that time-varying benefits arise for some Asian stock market investors from hedging energy price risk. These results add to existing work, both in the asset pricing and financial market integration literature, as well as providing new insights into the economic relationship between energy and financial asset markets.

The Asian stock markets possess varying degrees of integration with energy assets both at a portfolio and individual level. The temporal

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