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UNIVERSITY OF PARIS 1 PANTHEON SORBONNE

Master thesis
A wavelet-based approach to model oil and stock
market relationships



Student : Xuan Hoai VO
Supervisor: Dr.Duc Khuong NGUYEN
Professor, ISC Paris & University of Paris 1 Pantheon Sorbonne, France
Examiner: Dr. Christophe CHORRO
Professor, University of Paris 1 Pantheon Sorbonne, France



-Paris 11/2011-



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Abstract
This thesis aims to examine the relationships between crude oil and stock markets in OECD
countries by using a time scale decomposition based on the theory of wavelets. Our study
employs daily closing price data of Brent crude oil index and MSCI stock market indices for
the OECD. We first decompose oil and stock return series into different time components and
then investigate their relationships over the different time scales through wavelets estimated
variances and correlations. Our results mainly show evidence of significant time scale effects
on the behavior of the oil-stock market links, and that investors should consider these effects
when diversifying their portfolios of stocks into the oil asset.




















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Acknowledgement

I dearly thank my supervisor, Dr. Duc Khuong Nguyen, Associate Professor at ISC Paris
& University of Paris 1 Pantheon Sorbonne, for his guidance during the course of this thesis
and invaluable help gathering data as well as suggesting the topic. I would also like to thank
my friend, Dr. Amine Lahiani, Associate Professor, LEO, University of Orlans, for his
patience and support. I am grateful to my teacher, Dr. Christophe Chorro- Associate Professor
at University of Paris 1 Pantheon Sorbonne, for his helpful suggestions, guidance and
enthusiasm.
I would like to show my gratitude to colleagues and professors in University of Paris 1
Pantheon Sorbonne for science discussions and the pleasure working together and also all
Administrative Staffs of Erasmus Mundus program for providing the financial means and
laboratory facilities.
Last but not the least, I would like to thank my family for giving birth to me at the first
place and supporting me spiritually throughout my life.











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Contents

Abstract.................................................................................................................................... 2
Acknowledgement................................................................................................................... 3
1 Introduction.......................................................................................................................... 5
2 Overview of the worlds crude oil markets....................................................................... 10
3 Literature on oil-stock market relationships.................................................................... 20
4 Econometric method........................................................................................................... 23
5 Data...................................................................................................................................... 29
6 Empirical results................................................................................................................. 34
7 Conclusion............................................................................................................................ 40
8 Reference.............................................................................................................................. 42

















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1. Introduction
With oil prices cascading to new highs over the past few years, the topic of energy prices
has once again come to the fore. This section gives an introduction to some of the importance
of oil in the global economy as well as national economy. Before turning to some of the more
fundamental questions, we begin with a brief overview of the current situation. There is now
broad consensus among that oil price fluctuations impact global economic growth are
somewhat less than they did two to three decades ago. Yes, oil still packs a punch:
mainstream empirical estimates, including those analyzed and extended here, still suggest the
doubling of oil price increases between 2003 and 2005 cumulatively lowered global output by
at least 1.5% to date, or about 750 billion dollars. These same estimate suggest the effect is
likely to be at least as large in 2006 as in either of the preceding years. But, as significant as
these losses are, they still seem relatively modest half or less -- compared to conventional
assessments of the impact of the earlier oil shock episodes, which coincided (or nearly
coincided) with far more massive declines in global GDP growth. Instead, today, despite
record high oil prices, global growth is strong across virtually all regions of the world and
projected to remain so for the next year or two. Three or four years ago, trend global GDP
growth was thought to be in the range of 4% (for purchasing power parity weighted GDP).
Yet, the IMF (April 2006) is forecasting global growth of 4.9% in 2006 and 4.7% in 2007,
after 5.3% in 2004 and 4.8% in 2005. That is, despite oil prices having risen from $25 per
barrel in mid-2003 to nearly $114 as of this writing, growth is booming. Some of the answer,
of course, lies in the fact that recent oil prices increases have a strong demand component, but
things are not that simple, since uncertainty over supplies in Iran, Nigeria and Venezuela are
also having a clear effect. If oils impact has been diminished, then why has this happened? Is
it because of the more efficient use of energy resources have simply reduced the overall size
of energy consumption in global GDP by more than a third? Or is the reduced impact of oil
simply another example of what economists have more generally labeled The Great
Moderation, that is, the marked and continuing trend decline in global output volatility that
has taken place since 1985 across much of the world. That is, have deeper financial markets,
increasingly flexible labor markets, and perhaps most concretely, better global monetary
policy helped cushion oil shocks along with everything else? Or, is the reduced impact of oil
shocks simply an illusion perhaps like the Great Moderation itself due to a relatively
quiescent period in global volatility that may someday pass? Is the world failing to prepare
adequately for future energy shocks that may prove far more virulent than those of the past

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couple decades? Or, is what we are seeing simply a change in the locus of oils main impact,
with richer countries now affected less but poorer countries affected more? Perhaps oils
effects are less magnified in rich countries than before, as oil consumption increasingly
becomes concentrated in final goods consumption (mainly transportation and heating), rather
than manufacturing. If then, as Finn (2000) suggests, the main impact of oil shocks is on
capacity utilization, it is not surprising that the effect are less. But if energy prices are
becoming less central for richer countries, then for developing countries, the situation is quite
different. The migration of the worlds manufacturing base from North to South has arguably
left developing countries vulnerable to precisely the kind of economy-wide multiplier effects
that OECD countries experienced in the 1970s. So far this effect may have been masked by
strong overall global growth, but the concern is that this might prove temporary, and that
problems will express themselves at some point further into the current expansion cycle. The
possibility of a delayed response is heightened by concerns that the effects of oil prices are
being temporarily muted by a variety of policies around the world that may be unsustainable.
In many fast growing developing countries, governments have shielded businesses and
consumers from the price increases through various systems of controls. These controls
protect short-term growth, but at the cost of exacerbating long-run risks to financial stability
and government debt.
Oil has played a significant role in the economic and political development of the
industrialised countries in the world. Oil price shocks are an important determinant of the
future economic growth and stability of the developing countries of today. The economic
impact of higher oil prices on developing countries is generally more severe than that for
industrialised countries. This is mainly because of the energy intensiveness of these
economies as they experience a rapid economic growth and, generally, energy is used less
efficiently. According to the International Energy Agency report (2004), on average,
developing countries use more than twice as much oil to produce a unit of economic output as
do OECD countries. Economic liberalisation and integration of international markets is
characterised by an increased level of capital flow and international investment in emerging
markets. Given the oil intensity of the emerging economies of today, it is important for global
portfolio investors to understand the level of susceptibility of stock prices in these markets to
movements in global oil prices. Following the Asian and Russian financial market crisis in the
late 1990s, Brazil, Russia, India and China (BRIC) have emerged among the largest
countries in the world in both demographic and economic terms. These countries have seen

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their share in global GDP rise from 15 per cent in 1995 to 22 per cent in 2007. In financial
terms, the BRIC countries dominate the emerging market economies of today (Jensen and
Larsen, 2004). According to the Energy Information Administration (EIA) Report (2007), 18
per cent of the total annual oil demand in 2006 (84.6 million barrels per day) came from the
BRIC countries. Approximately 23 per cent of the total annual oil demand in 2030
(anticipated to increase to 117.6 million barrels per day) is expected to come from these four
countries, with 13.4 per cent coming from China alone.
Oil is one of the most important production factors in an economy. Not surprisingly, a
growing theoretical and empirical literature has been devoted to the study of oil and its impact
on the economy. Rising oil prices lead to higher production costs which affect inflation,
consumer confidence and therefore economic growth. Several studies report a clear negative
correlation between energy prices and aggregate output or employment. For instance,
Hamilton (1983) and Gisser and Goodwin (1986) demonstrate that rising oil prices are
responsible for recessions. Rotemberg and Woodford (1996) estimate that a 10% increase in
oil prices leads to an average GDP decline of 2.5% five or six quarters later. Jones et al.
(2004) estimate that the oil price GDP elasticity (the ratio of percentage change in GDP to
percentage change in oil price) is around0.06. However, Lee et al. (1996), Hamilton (1996),
Huntington(1998), among others, report an asymmetric relationship between oil prices and the
macroeconomy. Rising oil prices seem to decrease the aggregate economic activities more
than falling oil prices stimulate them. Furthermore, Bernanke (1983) and Pindyck (1991)
show that large oil price movements increase uncertainty about future prices and thus cause
delays in business investments.Nevertheless, Hooker (1996) indicates that the correlation
between oil prices and economic activity appears to be much weaker in data since 1985, so
the suggestion that oil shocks contribute directly to the economic downturn remains
controversial.
The connection between oil and stock prices appears to be quite natural. Theoretically,
the value of a firm is the present value of expected future cash flows. Rising oil prices affect
the future cash flows of a firm, either negatively or positively depending on whether the firm
is producing or consuming oil. In addition, oil prices also affect interest rates in the economy
via inflation and monetary policy of the central bank. Rising oil prices lead to high inflation
which increases interest rates. Furthermore, the central bank often uses contractionary
monetary policy to fight inflation. This further increases interest rates. As a result, the
discount rate of the firm also increases. Increasing discount rate leads to lower stock price,
other things equal.

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On the issue of the effect of oil price shocks on stock market returns, it has been
investigated by a number of researchers. Jones and Kaul (1996), Sadorsky (1999) and Ciner
(2001) report a significant negative connection, while Chen et al. (1986) and Huang et al.
(1996) do not. A negative association between oil price shocks and stock market returns has
been reported in several recent papers. Nandha and Faff (2008) find oil prices rises have a
detrimental effect on stock returns in all sectors except mining and oil and gas industries,
O'Neill et al. (2008) find that oil price increases lead to reduced stock returns in the United
States, the United Kingdom and France, and Park and Ratti (2008) report that oil price shocks
have a statistically significant negative impact on real stock returns in the U.S. and 12
European oil importing countries (Nandha and Faff (2008) review work on the effect of oil
price on equity prices. Recently papers have focused on the effect of oil price for stock market
risk as in Basher and Sadorsky (2006) and Sadorsky (2006)) In newstrands in the literature,
Kilian and Park (2007) report that only oil price increases driven by precautionary demand for
oil over concern about future oil supplies negatively affect stock prices, and Gogineni (2007)
finds that industry stock price returns depends on demand and cost side reliance on oil and on
size of oil price changes. Research on the effect of oil prices on stock prices parallels a larger
literature on the connection of oil price shocks with real activity. Much of this research has
been influenced by Hamilton's (1983) connection of oil price shocks with recession in the
U.S. Hamilton's finding has been elaborated on and confirmed by Mork (1989), Lee et al.
(1995), Hooker (1996), Hamilton (1996, 2003) and Gronwald (2008), among others (Cologni
and Manera (2008), Kilian (2008a) Jimenez-Rodriguez and Sanchez (2005), Cunado and
Perez de Garcia (2005) and Lee et al. (2001) have confirmed a negative link between oil price
shocks and aggregate activity for other countries. Huntington (2005), Barsky and Kilian
(2004) and Jones et al. (2004) provide reviews on the effect of oil shocks on the aggregate
economy). The research in the two areas is clearly connected, since oil price shocks influence
stock prices through affecting expected cash flows and/or discount rates. Oil price shocks can
affect corporate cash flow since oil is an input in production and because oil price changes
can influence the demand for output at industry and national levels. Oil price shocks can
affect the discount rate for cash flow by influencing the expected rate of inflation and the
expected real interest rate. The corporate investment decision can be affected directly by
changes in the latter and by changes in stock price relative to book value.
The modern portfolio theory suggests that investors seek to diversify their portfolios in
order to reduce the risk on the market. The previous literature has showed that commodities
asset class, and in particular crude oil asset, may provide good diversification potential due to

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their different nature and low correlations with stocks. However, most of the previous
research ignores the effects of different time horizon problem when studying the relationships
between crude oil prices and stock markets.
To solve the above issue and in order to better understand the underlying dynamics of the
oil price variable, and in fine to better assess its impact on the stock price, in this thesis we
intend to rely on wavelet methodology. In doing so, we focus on the usefulness and
performance of wavelets in providing out of sample forecasts for the oil prices. We also try to
deal with several associated issues and provide a balanced account of the problems and
promises. The applied procedure is motivated by some basic properties of wavelets and is
based on the application of the discrete wavelet transform (DWT) on time series of average
monthly crude oil prices. The idea is to subdivide the price data/signal in low and high
frequency part. By relying on DWT, the data is decomposed in several scales and coarse and
fine parts of the data are obtained. The coarse scales reveal the trend, while the finer scales
might be related to seasonal influences, singular events and noise. This is followed by an
appropriate and adaptive extension of the signal (which is depending on the behaviour on
each scale). Consequently, (out of sample) forecast values on each scale are calculated and the
inverse wavelet transform is used to generate a forecast for the whole signal.
In addition to this change relating to the data level, we also wish to set up a new time
level. The oil price specifications usually used in the literature (Mork, 1989; Lee et al., 1995;
Hamilton, 1996), implicitly consider that the relevant sphere of analysis of the oil pricestock
Market relationship is the simple time dimension. Despite the application of filters, the use of
VAR (Vector Auto Regressive) approach and other standard econometric tools, these
constructions only enable to separate short term fluctuations from the time trend. They do not
take into account the fact that the factors determining oil price fluctuations, as well as the
indicators of the economic activity, all operate at very different time scales. A tool that would
provide more subtle information, and would allow room for intermediate cycles' sizes, would
prove very useful in this matter. Such a tool does exist, and has been developed by the theory
of signal: the wavelet decomposition. In this thesis, we rely on the new framework offered by
wavelets to analyse the oil price cycles and to investigate the oil pricestock market
relationship.
In this thesis, we analyze the relationship between the price of crude oil and stock
markets in six OECD countries from OCT 2006 until Oct 2011. The basic method we employ
wavelet decomposition approach. We find a clear relationship, suggesting that evidence of

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significant time scale effects on the behavior of the oil-stock market links, and that investors
should consider these effects when diversifying their portfolios of stocks into the oil asset.
The remainder of the thesis is structured as follows. In the following section, we provide
a overview of the worlds crude oil markets. Literature on oil-stock market relationships (
theory and evidence) is contained in Section 3. Section 4 Econometric method is used - the
wavelet decomposition approach. Section 5 Description of sample data: Brent crude & 6
OECD countries, while Section 6 holds our main empirical results. Section 7 discussions and
concluding remarks. Data and sources are discussed in Appendix.
2. Overview of the worlds crude oil markets
Fig. 1 presents the Brent crude oil prices, in dollars, from Oct 2006 to Oct 2011. Oil
price movements show some important peaks and troughs during the period of the study. The
main peaks which are observed from Fig. 1 are in June 2008, where prices increased by more
than 60% since the January 2008 price levels. Another peak is observed in March 2011, which
was a result of a continuing increase in oil prices since 2009. The main troughs are observed
in January 2007, where prices fell by almost 40% compared to the mid-2006 prices, and in
early 2009, where oil prices fell by more than 70% compared to the June 2008 peak levels.
An important observation that can be made from the below graph is the fact that most of the
oil price changes occurred due to precautionary crude oil demand changes. However, there are
two aggregate demand-side oil price shocks. One occurred during the period 20072008,
which was a result from the rising demand of oil from China and the second demand-side oil
price shock took place in the recent global financial crisis of 2010.
High oil Prices and Robust Growth Can Co-Exist For a While?
The mid-2010 oil price assumption stands $15$20/bbl higher than in the 2010 outlook,
yet 2015 oil demand is also now 0.9 mb/d higher. The juxtaposition of tripledigit oil prices
and 45% global economic growth looks paradoxical, but partly reflects the time lags
affecting oil market dynamics. High prices and buoyant economic (and oil demand) growth
can coexist for a while. The market will ultimately adjust to higher prices, albeit supply and
demand remain unresponsive in the short term. Indeed, oils price inelasticity underpins the
recent extended upward price shift in the face of resilient nonOECD demand growth and
perennial supplyside risks. Todays global market balance shows that supply flexibility
upstream spare capacity and OECD inventories has diminished. The bull run evident since
autumn 2010 therefore looks in large part to be justified by supply and demand fundamentals.
Most analysts underestimated the near3 mb/d postrecession demand rebound in 2010.

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Indeed, baseline revisions for 2010 partly explain a now higher middecade demand
prognosis. And despite increased upstream activity levels and resurgent nonOPEC supply,
spare capacity has diminished. Overall, our businessasusual case (global GDP growth
averaging +4.5% per year) shows a tighter market during 20102012 than we envisaged back
in December. Market conditions potentially ease marginally during 20132016, although
arguably the 4 mb/d spare capacity implied for much of that period looks like a fairly thin
supply cushion.







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If tripledigit oil prices do begin to inhibit economic recovery, then our lower GDP case
suggests rising spare capacity and perhaps some temporary midterm relief from relentless
upward price pressures. One question mark, however, surrounds the robustness of supply in
such a lower GDP world. Our simplified model generates unchanged supply capacities in the
two cases. But as we note later, some North American expansion in nonOPEC supply
confronts potential pipeline and infrastructure constraints. In a lowergrowth world, project
slippage, together with potentially slower OPEC investment, might keep markets tighter than
the simplified low GDP balances suggest.


That said, high prices will ultimately lead to a correction. Efficiency gains and maturing
OECD markets will constrain demand. High prices have generated a more optimistic
nonOPEC supply outlook. But an eastward shift in the markets centre of gravity sustains
annual oil demand growth around 1 mb/d in both scenarios, amid rising incomes and sticky
price subsidies. This presents an ongoing challenge: OECD refiners face poor margins, yet
rising environmental investments to stay in business; upstream projects are more complex and
capital intensive. An ability to manage risk and sustain investment will be crucial for the
industry in the years ahead if further damaging price spikes are to be avoided
Oil Pricing
Last years relatively stable, if elevated, prices have given way to a renewed upward
surge, borne of tighter fundamentals, geopolitical risks and myriad market expectations for
economic growth, emerging market demand and concerns over the pace at which new supply
can be added. The price assumption that feeds our outlook now averages over $103/bbl.
Financial markets have augmented fundamentals in influencing shortterm prices, even if we
still believe that ultimately, market sentiment derives from prompt, and anticipated,

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supply/demand views. Popular wisdom has it that we live now with an inherently more
volatile oil market than in the past, and in which exchange rates and speculative money flows
actually drive oil price direction. Persuasive though such arguments may be, rigourous
analysis suggests otherwise. We argue here that oil prices may affect exchange rates more
than the converse. Moreover, levels of speculative activity, relative to risk hedging appetite
within the market, look to be below those of 2008. There is little evidence of todays oil
market being structurally more volatile than in the past. However, data gaps continue to
impede analysts ability to determine the relative role of specific physical and financial factors
in influencing price. Regulatory moves to increase transparency and minimise systemic risk in
commodity derivatives markets are welcome, although some market participants see risks of
regulatory arbitrage and unintended negative consequences, affecting price discovery, market
liquidity and the ability to hedge.

Oil Demand
Our demand baseline stands 0.6 mb/d higher than anticipated back in December, after the
stronger than expected postrecessionary surge in demand seen last year. Even the structurally
declining OECD markets saw a (likely shortlived) rebound last year. With a similar base case
GDP assumption (+4.5% annually through 2016), this higher baseline helps counteract a
significantly stronger oil price assumption ($103/bbl) to result in a demand outlook now 0.7
mb/d higher on average through 2016. Net oil demand growth of 7.2 mb/d during 20102016
(+1.2 mb/d annually) derives entirely from the nonOECD countries, with China alone
accounting for 41% of the total and other Asia and the Middle East a further 53% combined.
Income outstrips high crude prices in the growth markets in the face of persistent, if gradually
diminishing, enduser price subsidies. Critically, countries in the $3,000$20,000 per capita

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income takeoff range for oil demand will account for 45 mb/d of consumption by 2016, a
volume that will have nearly doubled in just 20 years. While China and others are not
expected to attain anything like the per capita oil use levels seen in the US and elsewhere in
the OECD, nonetheless favourable demographics, urbanisation and industrialisation push
demand in the emerging markets sharply higher. OECD demand contracts by 1.5 mb/d. That
decline is sharper than in our earlier projections, in part due to higher assumed prices

Transportation fuel use and gasoil/diesel predominate. Gasoil is now the fuel of choice in a
multitude of applications including transportation, as well as industrial uses and power
generation (with swing fuel characteristics akin to those previously held by residual fuel oil).
Tightening marine bunker sulphur specifications from middecade also suggest a growing role
for diesel at heavy fuel oils expense. Transportation accounts for two thirds of incremental
oil demand, although rising vehicle economy standards and growing biofuels use moderate
the demand for refinerysourced gasoline and diesel. The petrochemical sector also sees
significant growth, with feedstock demand rising by 1.7 mb/d between 20102016. New
capacity in Asia and the Middle East, much of it run on cheap ethane and LPG, places older,
naphthafed capacity in the OECD under intense competitive pressure. Any demand
projection faces uncertainties, with economic risk one of the most important. Twinning
weaker global GDP growth (3.3% annually) with slower gains in oil use efficiency results in
2016 demand some 2.4 mb/d lower than the base case, and implies annual demand growth of
0.8 mb/d. The implicitly lower crude price this scenario might entail could see a more
aggressive dismantling of price subsidies in emerging markets, further curbing demand, at
least in the short term. However, we think this will remain a step too far for policy makers,
and do not assume widespread reform except in those countries already embarked upon price
liberalisation. Shortterm demand uncertainties also include substitution, notably in power
generation. The years 2010 and 2011 have already shown that nonoil generation capacity
outages can boost global oil demand, particularly diesel, by 0.5 mb/d or more.

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Oil Supply
Global oil supply capacity increases from 93.8 mb/d to 100.6 mb/d by 2016, a net increase
averaging +1.1 mb/d annually. Incremental supplies are evenly split between OPEC crude,
OPEC gas liquids and nonOPEC total oil, and conventional crude oil accounts for less than
40% of the total increase. Sustained high crude prices have boosted upstream activity, and
although the spectre of resurgent costs and logistical constraints again hangs over the
industry, the slate of active new projects is more than sufficient to offset high rates of mature
oilfield decline. Based on fieldbyfield trends, the outlook assumes that 2010 baseline supply
loses over 3 mb/d annually, at a rate of approximately 5%, slightly lower than last years
estimate. Higher spending since early2009 has had a positive impact on existing assets, as
well as accelerating new projects. Nonetheless, this highlights the three-toone relationship
between decline and demand growth the industry confronts each year. High prices have
generated new supply, but nonOPEC growth is coming from higher cost areas. Libyan
production capacity is assumed to recover slowly after the ongoing civil war, regaining
prewar levels near 1.6 mb/d only in 2014. In contrast, significant OPEC crude capacity
growth is expected from joint venture investments in Iraq, Angola, and the UAE, with more
limited gains coming from Nigeria and Venezuela. A methodological change lifts recent
supply estimates for Venezuela by around 0.3 mb/d and modest net growth by 2016 derives
from joint venture investments in the Orinoco belt. An adverse investment climate, however,
sees Iranian crude capacity decline by 0.8 mb/d to 3.1 mb/d, falling below Iraqs capacity by
2014. Rapid natural gas developments drive OPEC natural gas liquid (NGL) and condensate
supply higher by 2.1 mb/d to 7.4 mb/d in 2016, based on major expansion from the UAE,
Qatar, Iran and Saudi Arabia.


The major adjustment to this years supply projections comes from nonOPEC, with 2015
output now 1.1 mb/d higher than in December. A more optimistic picture for North American

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supplies, and for US light, tight oil production in particular, underpins this view. Around 1
mb/d of net growth from this source is expected during 20102016, offsetting a weaker
postMacondo outlook for the US Gulf of Mexico. Nonetheless, global deepwater supply
increases in importance over the outlook period. Other key sources of nonOPEC supply
growth include Brazil, Canada, Kazakhstan and Colombia, plus biofuels, NGLs and refinery
processing gains. Global supply becomes marginally lighter, but sourer by 2016.
Crude Trade
Global interregional crude trade is expected to increase by 1.0 mb/d between 20102016
to reach 35.8 mb/d. This is a lesser increase than envisaged last year, as key producing regions
are seen refining more output locally and exporting products. The Middle East remains the
largest and key swing supply region, with exports increasing by 1.2 mb/d through 2014,
before declining as new regional refining capacity, particularly in Saudi Arabia, absorbs extra
crude volumes. Middle East sales average 16.7 mb/d by 2016, and exports to nonOECD Asia
rise by more than 1.7 mb/d.
Africa sees the sharpest rise in exports, up by 1.6 mb/d to 8.8 mb/d in 2016, led by Nigeria
and Angola. Asia again absorbs most of these extra volumes. While exports from the FSU
remain stable, we expect a reorientation of shipments, with deliveries to Pacific Rim reaching
1.4 mb/d by 2016, while sales into traditional European markets decline. Incremental crude
production from Latin America is expected mainly to be absorbed locally, although the region
remains an important supplier for North America. Despite rising demand for long haul crude,
tanker markets will continue to face weak profitability, amid strong growth in the fleet across
most classes of vessel.
There are four major benchmarks in the international oil market, namely West Texas
Intermediate (USA), Brent (North Sea), Dubai/Oman (Middle East), and Tapis (Asia-Pacific),
which are likely to be highly correlated

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Crude Oil Future & Option
Crude Oil options : Crude Oil options are option contracts in which the underlying asset is a
crude oil futures contract. The holder of a crude oil option possesses the right (but not the
obligation) to assume a long position (in the case of a call option) or a short position (in the
case of a put option) in the underlying crude oil futures at the strike price. This right will
cease to exist when the option expire after market close on expiration date.
Crude Oil Option Exchanges
Crude Oil option contracts are available for trading at New York Mercantile Exchange
(NYMEX). NYMEX Light Sweet Crude Oil option prices are quoted in dollars and cents per
barrel and their underlying futures are traded in lots of 1000 barrels (42000 gallons) of crude
oil. NYMEX Brent Crude Oil options are traded in contract sizes of 1000 barrels (42000
gallons) and their prices are quoted in dollars and cents per barrel.

Exchange & Product Name Underlying Contract Size Exercise Style Option Price Quotes
NYMEX Light Sweet Crude Oil Options 1000 barrel American Calls | Puts
NYMEX Brent Crude Oil Options 1000 barrel American Calls | Puts

Call and Put Options
Options are divided into two classes - calls and puts. Crude Oil call options are purchased by
traders who are bullish about crude oil prices. Traders who believe that crude oil prices will
fall can buy crude oil put options instead.
Buying calls or puts is not the only way to trade options. Option selling is a popular
strategy used by many professional option traders. More complex option trading strategies,
also known as spreads, can also be constructed by simultaneously buying and selling options
Crude Oil Futures: A futures contract is a legally binding agreement giving the investor the
right to buy/sell an underlying commodity at a fixed price on a future date. This contract gives
investors exposure to the international commodities market. The underlying instrument: light
sweet crude oil futures contract meeting all specifications as listed and traded on NYMEX, a
subsidiary of CME Group Inc.
Benefits
Easy access to the international market with a contract traded in local currency (ZAR)
Effectively manage price risk with a view on the international market
Effectively evaluate both the current and future world supply and demand for crude oil
Identify short term and long term price and volatility patterns for crude oil

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Hedge or gain exposure based on expectations of directional price, spread movement or
volatility in crude oil
Who should use this product?
Hedgers seeking to protect themselves against adverse price movements with a view that the
international market is a better hedge
Speculators hoping to make a profit on short-term movements in the futures contract price
How to use this product?
Register as a client with an authorised member firm
Deposit the required initial margin (good faith deposit) to be able to take out a sell or buy
futures position
Sell a futures contract to protect yourself against downside movement. Buy a futures contract
to protect yourself against upside movement Crude Oil Futures Trading Basics
Crude Oil futures are standardized, exchange-traded contracts in which the contract buyer
agrees to take delivery, from the seller, a specific quantity of crude oil (eg. 1000 barrels) at a
predetermined price on a future delivery date.
Crude Oil Futures Exchanges
We can trade Crude Oil futures at New York Mercantile Exchange (NYMEX) and Tokyo
Commodity Exchange (TOCOM).
NYMEX Light Sweet Crude Oil futures prices are quoted in dollars and cents per barrel and
are traded in lot sizes of 1000 barrels (42000 gallons).
NYMEX Brent Crude Oil futures are traded in units of 1000 barrels (42000 gallons) and
contract prices are quoted in dollars and cents per barrel.
TOCOM Crude Oil futures prices are quoted in yen per kiloliter and are traded in lot sizes of
50 kiloliters (13210 gallons).

Exchange & Product Name Symbol Contract Size Initial Margin
NYMEX Light Sweet Crude Oil Futures
(Price Quotes)
CL 1000 barrels
(Full Contract Spec)
USD 9,113 (approx. 23%)
(Latest Margin Info)
NYMEX Brent Crude Oil Futures BZ 1000 barrels USD 12,825 (approx. 29%)
TOCOM Crude Oil Future 1000 barrels JPY 210,000 (approx. 17%)

Crude Oil Futures Trading
Consumers and producers of crude oil can manage crude oil price risk by purchasing and
selling crude oil futures. Crude Oil producers can employ a short hedge to lock in a selling
price for the crude oil they produce while businesses that require crude oil can utilize a long

19

hedge to secure a purchase price for the commodity they need. Crude Oil futures are also
traded by speculators who assume the price risk that hedgers try to avoid in return for a
chance to profit from favorable crude oil price movement. Speculators buy crude oil futures
when they believe that crude oil prices will go up. Conversely, they will sell crude oil futures
when they think that crude oil prices will fall.
Crude Oil Options vs. Crude Oil Futures
Compared to the outright purchase of the underlying crude oil futures, crude oil options
offer advantages such as additional leverage as well as the ability to limit potential losses.
However, they are also wasting assets that has the potential to expire worthless.
Additional Leverage
Compared to taking a position on the underlying crude oil futures outright, the buyer of a
crude oil option gains additional leverage since the premium payable is typically lower than
the margin requirement needed to open a position in the underlying crude oil futures.
Limit Potential Losses
As crude oil options only grant the right but not the obligation to assume the underlying crude
oil futures position, potential losses are limited to only the premium paid to purchase the
option.
Flexibility
Using options alone, or in combination with futures, a wide range of strategies can be
implemented to cater to specific risk profile, investment time horizon, cost consideration and
outlook on underlying volatility.
Time Decay
Options have a limited lifespan and are subjected to the effects of time decay. The value of a
crude oil option, specifically the time value, gets eroded away as time passes. However, since
trading is a zero sum game, time decay can be turned into an ally if one choose to be a seller
of options instead of buying them.








20

3. Literature on oil-stock market relationships.
Economic theory suggests that any asset price should be determined by its expected
discounted cash flows (Fisher 1930; Williams 1938). Thus, any factor that could alter the
expected discounted cash flows should have a significant effect on these asset prices.
Consequently, any oil price increase would result to increased costs, restraining profits and in
greater extend, would cause a decrease in shareholders' value. Hence, any oil price increase
should be accompanied by a decrease in the stock prices. Should that effect be the same for
oil-importing and oil-exporting countries, though? Many authors argue that oil price effect on
stock markets is an indirect effect and it is fed through the macroeconomic indicators.
According to Bjornland (2009) and Jimenez-Rodriguez and Sanchez (2005), an oil price
increase is expected to have a positive effect in an oil exporting country, as the country's
income will increase. The consequence of the income increase is expected to be a rise in
expenditure and investments, which in turn creates greater productivity and lower
unemployment. Stock markets tend to respond positively in such event. For an oil-importing
country, any oil price increase will tend to have the opposite results; see LeBlanc and Chinn
(2004) and Hooker (2002). Oil price increase will lead to higher cost of productions, as oil is
one of the most important production factors (Arouri & Nguyen 2010; Backus & Crucini
2000; Kim & Loungani 1992). The increase cost will be transferred to the consumers, which
will, in turn, lead to lower demand and thus consumer spending, due to higher consumer
prices; see for example, Bernanke (2006), Abel and Bernanke (2001), Hamilton (1996),
Hamilton (1988a, 1988b) and Barro (1984). Lower consumption could lead to lower
production and thus increased unemployment; see Lardic and Mignon (2006), Brown and
Ycel (2002) and Davis and Haltiwanger (2001). Stock markets would react negatively in
such case; see Sadorsky (1999), and Jones and Kaul (1996). However, we should not lose
sight of the fact that oil price shocks could affect stock markets due to the uncertainty that
they create to the financial world, depending on the nature of the shock (demand side or
supply-side). In this case stock markets could respond positively to an oil price shock, which
originates from the demand side, and negatively if the shock originates from the supply side.
Having briefly discussed the possible transmission mechanisms of an oil price shock to the
stock market, we proceed to the analysis of the previous studies in this area. Mounting
evidence suggests a negative relationship between oil prices and stock market returns. Jones
and Kaul (1996) were the first to reveal the negative impact of oil price on stock markets,
which occurs due to the fact that oil price, is a risk factor for stock markets. Other authors,

21

such as Filis (2010), Chen (2009), Miller and Ratti (2009), Nandha and Faff (2008), O'Neill,
Penm, and Terrell (2008), Park and Ratti (2008), Driesprong, Jacobsen, and Maat (2008),
Ciner (2001) and Gjerde and Sttem (1999) have also provide evidence towards such a
negative relationship. Sadorsky (1999) argued that oil price volatility has also an impact on
stock returns. Oberndorfer (2009) seconds that opinion in his study on the effect of oil price
volatility on European stock markets. A negative relationship between the volatilities of oil
price returns and three stock market sectors returns in US (namely, technology, health care
and consumer services) was identified by Malik and Ewing (2009). Similar results were
obtained by Chiou and Lee (2009). More specifically, Chiou and Lee (2009), using an
Autoregressive Conditional Jump Intensity (ARJI) model, found evidence that oil price
volatility negatively influence the S&P500 index. More importantly, their study concluded
that periods of increased oil price volatility tend to cause unexpected asymmetric negative
effects on S&P500 returns. Hammoudeh and Li (2008) provided an interesting finding in this
area of concern. They suggested the major events that cause changes in oil prices tend to
increase the stock market volatility of the GCC countries. In addition, Arouri and Nguyen
(2010) used a two-factor GARCH model to examine the effect of oil prices on European
sectors returns rather than only on aggregate stock market index returns. They concluded that
oil prices tend to exercise a significant influence on various European sectors (such as, Oil
and Gas, Financials, Industrials and Utilities, among others); however, the magnitude and the
direction of the effect differ from one sector to another. Specifically for the oil-exporting
countries, Arouri and Rault (2011) employed a bootstrap panel cointegration technique and a
seemingly unrelated regression (SUR) method and provided evidence that positive oil price
shocks have positive impact on the stock market performance of GCC countries. Similar
results were also documented by Bashar (2006). Hammoudeh and Aleisa (2004), on the other
hand, found a bidirectional relationship between oil prices and stock markets, in oil-exporting
countries. Other studies concentrate their interest in the investigation of the oil price shock
origin, i.e. demand-side or supply-side shock. These studies include Hamilton (2009a,b),
Lescaroux and Mignon (2008), Barsky and Kilian (2004) and Terzian (1985). The origin of an
oil price shock is an important component when studying the relationship between oil prices
and stock markets. In particular, Lescaroux and Mignon (2008) suggest that supply-side
shocks could be related to higher oil price volatility, although it may not be the only reason.
Demand-side shocks also justify high oil price volatility. In addition, Hamilton (2009b)
argued that demand-side shock deriving from industrialization of countries such as China
could have a significant impact. He also voiced the opinion that lack of immediate response of

22

oil-supply to a large scale increase in oil-demand could result to a demand-side shock. Kilian
and Park (2009) advocated that demand side oil price shocks influence stock prices more than
the supply-side oil price shocks. Demand-side oil price shocks exercise a negative influence
on stock prices due to the precautionary demand for crude oil, which echoes the uncertainty of
future oil supply availability.However, they suggested that if the demand-side oil price shock
is driven by global economic expansion, then higher oil prices will cause a positive effect on
stock prices, which is in line with Hamilton's (2009b) views. All that said, a wealth of
literature suggests that there is no relationship between oil price and stock markets; see for
example Cong, Wei, Jiao, and Fan (2008), Haung, Masulis, and Stoll (1996) and Chen, Roll,
and Ross (1986). Concerning the oil-exporting countries, Al Janabi, Hatemi-J, and Irandoust
(2010) used bootstrap test for causality appropriate for non-normal financial data with time-
varying volatility and concluded that GCC stock markets are informationally efficient with
regard to oil prices, i.e. oil prices do not tend to affect these stock markets and thus oil prices
cannot be used as predictors for the GCC stock markets. Specifically for oil-importing
countries, Al- Fayoumi (2009) found no evidence that oil price shocks affect the stock
markets. Other authors suggest that oil prices do not seem to have any effect in the economy
after the 1980 s (Bernanke, Gertler, & Watson 1997; Blanchard & Gali 2007; Hooker 1996,
2002; Lescaroux & Mignon 2008; Nordhaus 2007). Miller and Ratti (2009) concluded that oil
price effects are insignificant after 1999 due to oil price bubbles which have taken place since
the early 2000. Jammazi and Aloui (2010) and Apergis and Miller (2009) painted the same
picture suggesting that oil prices do not affect stock market performance. Such conclusions
could originate from the fact that oil prices are not any more a significant source for economic
downturn, as was suggested by Hamilton (1983). Nowadays, the majority of the countries
have turned the focus of their monetary policy on inflation stability putting an effort to the
absorption of any shocks that could cause inflationary pressures e.g. oil price shocks
(Bernanke et al. 1997; Blanchard & Gali 2007; Lescaroux & Mignon 2008). Furthermore, due
to increased productivity, investments and renewable energy sources, firms are able to absorb
increased production input costs without the need of price increases (International Energy
Agency 2006). Wage flexibility plays an important role on the reduced impact of oil price
shocks, as well. Nordhaus (2007) suggested that due to the greater wage flexibility in some
countries, responses to oil price shocks tend to be more neoclassical rather than Keynesian.
Similar evidence was adduced by Blanchard and Gali (2007). Neoclassical theory, in contrast
to the Keynesians, argues that effect on output is much smaller and thus oil price shocks

23

should have minimum impact in the economy. Hence, according to this theory, oil price
shocks should have small or no impact on stock markets today, as well.
4. Econometric method
4.1.Introduction
Although wavelets are known to have significant impact and widespread application in a
variety of scientific fields (such as hydrodynamics, geophysics, data processing, image
compression, detection of discontinuities, neural networks, etc.), the wavelet methodology
appears to be an uncharted territory in the realm of social sciences. Only recently, a few
studies rely on the wavelet methodology as a viable tool for studying dynamic properties of
different financial and economic phenomena. The origins of wavelet methodology can be
traced to the classic theory of harmonic analysis and the seminal contributions of Joseph
Fourier, Alfred Haar and Paul Levy. Since the appearance of the pioneering work of Morlet
and Grossman in 1980s [1] wavelet methodology has been introduced to the literature as a
regular alternative for analysing irregular situations where the data/signal contains scaling
properties, discontinuities, sharp spikes etc. (see [2] for details) These contributions were
followed by the introduction of the general idea of multi-resolution analysis by Mallat and
Meyer and the notion of orthogonal wavelet bases by Daubechies in 1980s [35]. Fortunately,
the conceptual framework of multi-scale analysis and discrete wavelet transformations seems
to have the potential to become a useful vehicle for exploring and understanding various
dynamic features of economic time series. As a matter of fact, during the last ten years or so, a
few wavelet related studies of financial forecast strategies have surfaced in the literature (see
[69]). Ramsey [10] provides a general review of wavelet literature in economics and finance
and puts a few interesting contributions in perspective. Alongside other issues, Ramsey also
considers a few problems and potentials associated with the application of wavelets for
forecasting economic/financial series. Our study is partly motivated by these considerations.
Around 25 years ago researchers started to use wavelets as an alternative to Fourier
transform for the analysis of acoustic and seismic signals that usually pose singularities and
irregular transients [1]. In contrast to regular Fourier transforms (e.g. various manifestations
of extended trigonometric functions), wavelet analysis works with translates and dilates of a
single local function : the mother wavelet. An advantage of the wavelet transform in
comparison with the Fourier transform is that the wavelet coefficients reflect in a simple and
precise manner the properties of the underlying function. A mother wavelet is locally defined,
i.e. it either should have compact support or decay sufficiently fast. It implies that small

24

changes in the signal have only limited influence on the coefficients of the corresponding
wavelet representation. The existence of mother wavelets (with compact support and certain
smoothness) is not a trivial analytical issue and details concerning the construction of a class
of compactly supported wavelets with arbitrary smoothness were first addressed by
Daubechies in the late 1980s [11]. Daubechies work provides a reliable vehicle for obtaining
orthogonal wavelet bases by translating and dilating the mother wavelet. A mother wavelet
with compact support is located in a finite interval. It implies that a singularity can be
analysed by considering only those translates of which overlap the singularity. Finer details
can be analysed by scaled versions of with smaller support. Consequently, the local analysis
of a function is possible with the aid of only few basis functions. On the other hand by using
wavelets we obtain a decomposition into scales of different resolution (the so called multi-
scale decomposition).
As far as the analysis of economic time series (e.g. commodity prices) are concerned, the
presence of scaling relations can be used to characterize the statistical properties of the
underlying process and to provide alternative means for dealing with the volatility issue and
other issues related to conditional moments (mean, variance, etc.).
As regards the present study, we intend to confine our efforts to a general application of
multi-scale analysis as it is understood in wavelet literature. The basic idea is to consider a
signal which can be decomposed by wavelet transform in different scales. The scales contain
contributions of the signal of different frequencies. When embedded in an appropriate
function space, the multi-resolution (or multi-scale) analysis of a function (or signal or time
series) can be performed.
4.2. A multi-resolution analysis of the oil price and stock market returns
4.2.1. Rationale for a multi-level decomposition of the oil price
As was mentioned above, previous contributions have already attempted to provide a
relevant decomposition of the oil price, in order to better understand the oil price impact on
the stock price. In addition to Mork's (1989) decomposition of the oil price into two
components, increases and decreases, Lee et al.'s (1995) surprise effect measure, and
Hamilton's NOPI (1996), Kilian (2006) also decomposed the oil price shocks into 3 shocks,
using a Structural VARmodel: supply shocks, aggregate demand shocks (that also affect other
commodities) and oil specific demand shocks (that only affect the oil demand). Thanks to this
decomposition, he could show that oil supply shocks, that have been the most studied ever
since the early 1970s, only explain a marginal part of the oil price variations, compared with
both kinds of demand shocks. These transformations of the oil price, prove that the oil price

25

should not be studied as a gross variable anymore, since a lot of information is lost by doing
so. However, despite the precious information they yield, these specifications do not address
an essential characteristic of the oil price: the diversity of the factors causing its variations. At
best, Kilian (2006) manages to decompose the oil price into three global components, but it
does not suffice to fully take into account the complexity of the factors driving the oil price.
The causes of the oil price rises we have witnessed for the last decade are indeed numerous.
Regarding the offer side first, we can find the following explanations: (i) the low investment
in the oil industry during the 1990s has led today to an under-capacity of oil facilities
(exploration, production and refining); (ii) the scarcity of the resource (some countries have
already reached their oil peak) creates uncertainty which also contributes to drive oil prices
up; (iii) geopolitical instability affects many of the oil producing countries (gulf wars, rebels
in Nigeria, the nuclear crisis with Iran, growing and aggressive nationalism in SouthAmerica
and in Russia); (iv) the rise of the costs of many production factors (price of other
commodities, costs of sub-contractors) increases the cost of major energy projects; (v)
OPEC's decisions of cuts in production; (vi) information about low US' oil stocks; and (vii)
some extreme climate events which damage oil facilities. Turning now to the demand side,
the rise in oil demand stemming from China, India and other emerging countries, and the
stable energy demand from advanced countries constitute potential explanations of the oil
price increases. These factors, whether on the offer or on the demand side, all operate at very
different time horizons: a few hours for an OPEC meeting, a few days for strikes in
Venezuela, a few months for attacks in Nigeria, a few years for the IranIraq war and the 2nd
Gulf war and up to 20 years or more for energy investment policy in the oil sector or in
substitution energy sources. The diversity of these time horizons induces diverse underlying
cycles in the variations of the oil price. Shocks that may affect these cycles do not have the
same impact on the oil price: a hurricane in the United States will damage the capacity of
some refineries or off shore platforms for a while, but their impacts on the oil price cannot be
compared to a permanent rise in Chinese demand for oil or to the lasting cut in Iraq's oil
production. In order to better understand the underlying dynamics of the oil price variable,
and in fine to better assess its impact on the stock price, it is essential to separate these various
contributions according to their own time scales. To reach this objective, the wavelet theory,
part of the theory of signal, is a powerful tool.
4.2.2.The wavelet theory
To decompose a given signal, continuous or discrete, the theory of signal is a sensible
approach. Among the many tools available in the theory of signal, one of the most famous

26

would be the Fourier Transform. It consists in projecting a signal on a basis of sines and
cosines, each with their own frequency. The result of such a projection is a frequency by
frequency decomposition of a given signal. Yet, by transforming a signal in such a manner, all
time related information is lost: any abrupt change is not captured by the Fourier Transform
since its harmonics are globally defined and do not depend on the time variable. This feature
therefore makes the Fourier Transform only suitable for the analysis of stationary signals.
Gabor (1946) attempted to overcome this flaw by applying the Fourier Transform on a short
time window which he would slide along the observations vector. His method known as the
Short-Time Fourier Transform, is hence equivalent to performing time local Fourier
Transforms. However, Huang et al. (1998) pointed out that the window must be thin enough
to localize time changes, which necessarily induces a loss in the frequency resolution. The
wavelet transform provides a solution to the above-mentioned problems. It is similar to the
Fourier Transform in that it also consists in projecting a signal x(t) onto a basis of functions
(real or complex), but unlike sines and cosines, these functions are constrained to hold
specific properties. This family of functions called daughter wavelets are obtained by
rescaling and translating a single function, the mother wavelet which has to comply with
the following constraints:
- The mother wavelet must have 'unit energy, which means that
2
( ) 1 t dt

(1)
The mother wavelet must comply with the admissibility condition, which states that
( ) f
df
f

where 4 is the Fourier TransIorm oI . This condition implies that we have

] (t)Jt = 0
+
-
(2)
Fig. 0(a) shows an example of such a mother wavelet. It is the Morlet wavelet, which has the
Iollowing deIinition: (t)
If the wavelet verifies conditions (1) and (2), it is possible to create the wavelet family

s,t
(t) by simply rescaling and translating :


27


Fig. 0. (a) Representation of the real part of a Morlet wavelet, with
Irequency e0=10. Conditions (1) and (2) ensure that the wavelet is
different from 0 but decays down to 0 fast enough. This wavelet is
the mother wavelet. The admissibility condition also ensures that
it is possible to recover x, the original variable, from its projection
on the wavelet family. (b) A daughter wavelet, rescaled and
translated with parameters s=4 and t2. (c) Another daughter
wavelet, with parameters s0.25 and t2.
where s is the scaling Iactor, and t the
translating one (the square root of s is used
here to keep the unit energy).
Fig. 0(b) and (c) shows two daughter
wavelets obtained by rescaling and
translating the Morlet mother wavelet. Once
the wavelet family is identified, it is possible
to obtain the wavelet transform by projecting
the signal x(t) on this set of functions. The
wavelet coefficients obtained are of the
following form:

is the complex conjugate wavelet oI
s,t
. This
transform is called the Continuous Wavelet
Transform (CWT) as parameters s and t can
take any real value (i.e. there are an infinite
number of wavelet coefficients). However, it
can be shown that information contained by
the wavelet coefficients WT(s,t) is not lost
when s and t are made discrete, which
considerably simplifies the computation of
the wavelet transform. The most common
method to discretize the parameters while keeping the relevant information is to use
parameters of the following form: s=2
j
and tk2
j
where j and k are integers. This new
transform is called the Discrete Wavelet Transform (DWT). So far, we have considered that
the signal was a function of a continuous time variable t. However, in economic time series,
observations are more often than not discrete, which brings us to the following expression of
the wavelet coefficients, strictly equivalent to the expression found in the continuous time
variable case:

where * is the complex conjugate wavelet oI and N is the number of observations. j is the
level of decomposition (the timescale) of the transform, and takes every integer value between
1 and J, where J is the highest level (also called the overall depth of the transform). For j=1,

28

N/2 coefficients are calculated which correspond to short cycles (high frequency components
of periods comprised between 2
1
and 2
2
months). For j=2, N/4 coefficients are calculated of
periods comprised between 2
2
and 2
3
months. Until we get to j=J, the coarsest decomposition
level (N/2
J
coefficients), corresponding to the largest intervals (i.e. long cycles of periods
superior to 2
J
months). It must be noted that N/2
J
>1, which implies that the highest resolution J
that can be obtained with a given discrete signal is necessarily inferior or equal to log
2
(N).
The coefficients' sub sampling method described above presents a drawback in the case of the
DWT: in order to exactly cover the sample of finite observations without having to pad the
sample with extra zeros or by using polynomial extrapolations, we must use time series with
size N equal to a multiple of a power of 2 (dyadic length vector of observations). Indeed, we
need to be able to divide by two the sample size as many times as the decomposition level
requires. In order to overcome this major drawback, as dyadic length vectors of observations
are rare, we can use another kind of transform, the Maximum Overlap Discrete Wavelet
Transform (MODWT). The difference between the MODWT and the DWT lies in the fact
that the translations are now oI the Iorm tk, k being an integer. For this kind of sampling,
there is no more need to extend the observation vector to obtain a dyadic size, as now every
level contains the same number of wavelet coefficients, equal to the number of observations
N. Moreover, the MODWT provides a wavelet variance estimator which is asymptotically
more efficient than the one based on a DWT analysis. As stated in condition (2), the mother
wavelet must integrate to 0. However, the signal we want to decompose does not necessarily
integrate to 0, hence the projection of x(n) on the set of wavelets will only provide
information about its fluctuations, not about its trend. Therefore we need another kind of
Iunction which integrates to 1, the scaling function on which to project the signal, and
which will serve to approximate the trend of the signal. We have therefore the final condition:
_ (t)Jt = 1
+
-

The projection of x on the mother wavelet and its daughters will provide the detail
coefficients, corresponding to the high frequency components of the signal, while its
projection on the scaling function and its daughters will provide the smooth coefficients,
corresponding to the trend. In the case of the MODWT, the projections of x(n) on these two
types of wavelets are of the following forms:
- Detail coefficients:

29


- Smooth coefficients:

These two kinds of coefficients provide an additive decomposition of the original signal,
thanks to the following formula: xt =
This additive decomposition is what we call a multi-resolution analysis, and
which we will use later in this thesis. As this thesis is aiming at better understanding the
relationship between variables, wavelet variance, correlation are very useful tools. The
wavelet variance at level j is given by:

Where: L
j
=(2
j
1)(L1)1 is the width oI the wavelet Iilter at level j, and L being the overall
width of the wavelet. M
j
=NL
j
+1, L is the number of wavelet coefficients unaffected by the
boundary conditions. Assuming that the signal x follows a Gaussian process, we can therefore
deduce the confidence interval for the variance. Then using the variance formula, we can
obtain the correlation which we will use later in this thesis.
5. Data
We collect daily data for the six member-countries of the OECD (Denmark, Finland,
France, Germany, Norway, United Kingdom) over the period from Oct 25, 2006 to Oct 18,
2011. Stock market indices are obtained from MSCI database, while oil price data are
extracted from the Energy Information Administration (EIA). The Brent spot prices are used
to represent the international crude-oil market since they usually serve as reference prices for
pricing crude oil and many other derivatives products using oil as underlying asset. Unlike the
majority of previous studies which employ low frequency data (yearly, quarterly, monthly,
and weekly), we use daily data in order to adequately capture the rapidity and intensity of the
dynamic interactions between oil and stock prices in the OECD. All price data are
denominated in US dollars to take into account the impacts of exchange rates and to ease the
comparison across countries. Daily returns are calculated from daily price data by taking the
natural logarithm of the ratio of two successive prices. The statistical properties of the data are
summarized in Table 1, Table 2.

30

Table 1 : Descriptive Statistics
BRENT DENMARK FINLAND France GERMANY NORWAY UK
MEAN 0.052 -0.003 -0.045 -0.033 -0.015 -0.007 -0.026
MINIMUM -16.832 -13.512 -10.188 -11.566 -9.637 -14.225 -10.421
MAXIMUM 18.130 10.713 11.569 11.844 11.589 15.394 12.161
Std. Dev 2.455 1.946 2.269 2.071 2.017 2.747 1.909
SKEWNESS 0.005 -0.202 -0.051 0.037 -0.049 -0.379 -0.071
KURTOSIS 9.013 8.106 6.199 8.018 7.606 6.988 9.344
Jarque-Bera 1883.428
[0.000]
1366.545
[0.000]
533.718
[0.000]
1312.009
[0.000]
1105.308
[0.000]
858.337
[0.000]
2096.979
[0.000]
ARCH(5) 14.731
[0.000]
82.921
[0.000]
20.874
[0.000]
41.349
[0.000]
41.031
[0.000]
60.683
[0.000]
67.972
[0.000]
ARCH(10) 9.7382
[0.000]
46.48
[0.000]
16.878
[0.000]
27.653
[0.000]
32.928
[0.000]
47.476
[0.000]
39.895
[0.000]
Q(10) 21.767
[0.016]
30.279
[0.000]
15.937
[0.101]
22.247
[0.013]
6.516
[0.770]
13.843
[0.180]
28.802
[0.000]
Q(10) 183.308
[0.000]
963.059
[0.000]
311.107
[0.000]
552.550
[0.000]
604.832
[0.000]
954.934
[0.000]
797.628
[0.000]

Note: This table provides the basic statistics of daily cride-oil returns for 6 countries of the OECD. Data are over the period from Oct 25,
2006 to Oct 18, 2011. They include mean (Mean), standard deviation (Std. dev.), minimum (Min.), maximum (Max.), skewness (Skew.),
kurtosis (Kurt.), and i Ljung-Box Q(10). JB refers to the empirical statistic of the JacqueBera test for normality. ARCH(5), ARCH(10) are
the empirical statistic of the Lagrange Multiplier test for ARCH in the residuals, which considers three lagged values chosen using
information criteria.
In Table 2, we test for the presence of unit roots in the levels (price series in logarithm)
and first differences (return series) of oil and stock market price indices. The results from the
Augmented DickeyFuller (ADF) tests indicate that the price series are integrated of order
one. All the return series do not have unit roots. To check whether our unit root test results are
robust to the presence of a potential structural break we implement the PP unit root test where
break dates are endogenously determined within the model. Our findings show that the null
hypothesis of a unit root cannot be rejected for all the price series with the exception of oil
prices, while it is clearly rejected for all the return series.
We report, in Table 1, basic statistics of return series. Average daily returns on OECD stock
market indices are all negative over our sample period under the effects of the recent global
financial crisis 20072009, sparked by the US subprime crisis. The stock market in Filand
realized the worst performance (0.045%), followed by those in the France and UK.

31

Inversely, the oil market experienced a positive average return,which is not surprising in view
of the increasing trend in the price of oil over the last decade. Skewness is negative for all
stock markets except for France, and positive for the oil market. This means that extreme
negative and positive returns are likely to be realized for stock and oil markets respectively.
Kurtosis coefficients are important in size and highly significant, indicating that outliers may
occur with a probability higher than that of a normal distribution (They have fatter tails and
longer left tails than a normal distribution). Accordingly, the JarqueBera test statistics
strongly reject the null hypothesis of normality for all series. As also shown in Table 1, all the
return series were found to have a leptokurtic behavior (i.e., their distributions have fatter tails
than corresponding normal distributions). This suggests that each of the mean equations
should be tested for the existence of conditional heteroskedasticity. By applying the Engle
(1982)'s test, we observe that the null hypothesis of no ARCH effects is rejected at
conventional levels in all cases, thus confirming that GARCH modeling is adequate for
capturing any persistence in the financial volatility of stock and oil markets we consider. All
these facts support our choice to use the quasi-maximum likelihood (QML) estimation
method.
Table 2 : Unit Root Tests
BRENT DENMARK FINLAND FRANCE GERMANY NORWAY UK
ADF -
34.783
***a

-34.427
***a
-35.950
***a
-
35.784
***a

-34.644
***a
-35.900
***a
-
36.056
***a

PP -
34.779
***a

-34.434
***a
-36.032
***a
-
35.913
***a

-34.645
***a
-35.942
***a
-
36.459
***a

(a) Refers to the Augmented Dickey-Fuller test without trend nor intercept. From these results, the data rejects unit root

Fig. 1 depicts the time-paths followed by different stock market returns & oil price series.
Some signs of volatility clustering and persistence can be observed. Further, the presence of
several sudden changes in the time series may indicate the occurrence of structural breaks. We
also perform the Ljung-Box and Engle (1982) LM ARCH tests to further analyze the
distributional characteristics of oil return series (Table 1). These tests provide clear indication
of autocorrelation and ARCH effects in the series considered. In contrast, the West and Cho
(1995) modified Ljung-Box test, which is robust to conditional heteroscedasticity, shows that
autocorrelation is significantly present at the conventional levels only in seven series .

32


Fig. 1 : Dynamic of OECD Stock markets indices & Brent oil prices

Fig. 2 : Returns
BRENT
2007 2008 2009 2010 2011 2012
50
100
150
BRENT
DENMARK
2007 2008 2009 2010 2011 2012
4000
6000
DENMARK
FINLAND
2007 2008 2009 2010 2011 2012
500
750
1000 FINLAND FRANCE
2007 2008 2009 2010 2011 2012
1000
1500
2000
2500
FRANCE
GERMANY
2007 2008 2009 2010 2011 2012
1500
2500
GERMANY
NORWAY
2007 2008 2009 2010 2011 2012
2000
3000
4000
5000
NORWAY
UK
2007 2008 2009 2010 2011 2012
1000
1500
UK
BRENT
2007 2008 2009 2010 2011 2012
-10
0
10
20
BRENT
DENMARK
2007 2008 2009 2010 2011 2012
-10
0
10
DENMARK
FINLAND
2007 2008 2009 2010 2011 2012
-10
0
10
FINLAND France
2007 2008 2009 2010 2011 2012
-10
0
10
France
GERMANY
2007 2008 2009 2010 2011 2012
0
10
GERMANY NORWAY
2007 2008 2009 2010 2011 2012
-10
0
10
20
NORWAY
UNITED
2007 2008 2009 2010 2011 2012
-10
0
10
UNITED

33


Fig. 3 : Squared returns
As to Figures 2 and 3, Figure 2 shows the time-variations of stock returns through time.
We observe that both Brent oil and stock markets in Europe have experienced alternatives
periods of overvaluation and undervaluation. Typically, all the return series display some
extreme positive and negative returns over the 2008-2009 period, indicating the potential
effects of the global financial crisis. Figure 3 depicts the evolution of the squared returns,
usually viewed as a measure of financial volatility. It can be seen that oil and stock returns are
particularly volatile between the end of 2008 and the beginning of 2009. Moreover, the
volatility dynamics seem to be sharply time-varying and clustered because the periods of high
volatility tend to be followed by periods of high volatility, and periods of low volatility by
periods of low volatility. Hence, a time-varying volatility model such as GARCH-family
processes should be appropriate for modeling the volatility dynamics of Brent oil and stock
market returns.
6. Empirical results
6.1 Return decomposition: A multi-resolution analysis of the oil price and stock returns
As variable for the oil price, we use the logarithm of the spot price Brent, provided by
the Energy Information Agency, on a daily basis, from Oct 2006 until Oct 2011. We therefore
BRENT
2007 2008 2009 2010 2011 2012
100
200
300
BRENT
DENMARK
2007 2008 2009 2010 2011 2012
50
100
150
200
DENMARK
FINLAND
2007 2008 2009 2010 2011 2012
50
100
150
FINLAND FRANCE
2007 2008 2009 2010 2011 2012
50
100
150
FRANCE
GERMANY
2007 2008 2009 2010 2011 2012
50
100
150
GERMANY NORWAY
2007 2008 2009 2010 2011 2012
100
200
NORWAY
UK
2007 2008 2009 2010 2011 2012
50
100
150
UK

34

have a vector of 1251 observations, which enables us to use 7 levels of wavelet
decomposition. As mentioned above, we use the MODWT transform for the decomposition.
Regarding the choice of the wavelet function, we follow the advice given by Genay et al.
(2002) which states that the longer the length of the wavelet, the better it approximates an
ideal band pass filter. Given the shape of the original series, which is rather smooth, we
therefore choose the Least Asymmetric wavelet of level 8, LA(8) (8 is the width of the filter),
as the wavelet function. The various decomposition levels we obtain correspond to time
scales: D1 (2 to 4 months), D2 (4 to 8 months), D3 (8 to 16 months), D4 (16 to 32 months),
D5 (2.7 to 5.3 years), D6 (5.3 to 10.6 years), D7 (10.6 to 21.3 years). We also obtain a smooth
S7 which corresponds to the trend of the signal, while the details Dj correspond to
fluctuations of various sizes. From Fig. 4 to Fig. 10 represent the details D1 to D7 and the
smooth S7, obtained by applying the LA(8) to the oil price & stock market returns variables.
Given the properties of the wavelet decomposition, each detail represents the contribution of
fluctuations of a specific time scale to the oil price variations & stock market returns
variations, while the smooth S7 represents its trend. From these figures, we can see that, in a
country each time scale has a dynamic of return and dynamics of six coutries are different at
the same levels. The shape of the smooth, which is continuously increasing & decreasing
throughout the whole sample. Turning to the wavelet details on Fig. 4-Fig. 10,we note that
they are able to capture the classical oil shock events & stock returns. At the smallest level D1
(2 to 4 month scale),we observe a clear rupture in 2009, corresponding to the economic crisis
2008-2009. At level D2, (4 to 8 month scale) we can see an additional significant rupture in
4/2010. At levels D5(app. 2.7 to 5.3 years scale) and D6(app. 5.3 to 10.6 years scale), smaller
shocks are merged into larger oil price movements. Another feature which can be observed
from Fig. 4-Fig. 10 is the cyclical shape of all details, especially of the larger ones, which
exhibit troughs and peaks in a regular manner. This fact does not constitute a surprise in itself,
as it is common for macroeconomic variables to follow cycles.
It is useful to note that the Multi-Resolution Analysis is an additive decomposition of the
original signal. When considering Fig. 4-Fig. 10, this additive decomposition property implies
that the dot - curve is equal to the sum of all blue curves (d(log(Oilt))=D1+D2+D7+smooth
S7). Therefore,
d],t
0It
the percentage contribution of detail j to the oil price variations at time t.

35


Fig 4 : Multi-resolution of oil price (Logarithm of the Brent, between October 25, 2006 and October 18, 2011 on a daily basis). The top right
cell represents the trend (S7) and the original oil price curve.

Fig 5 : Multi-resolution of stock market returns (Logarithm of DENMARK, between October 25, 2006 and October 18, 2011 on a daily
basis). The top right cell represents the trend (S7) and the original oil price curve..
S BRENT
2007 2008 2009 2010 2011 2012
4.0
4.5
5.0
S BRENT
D1
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
0.2
D1 D2
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D2
D3
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D3 D4
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D4
D5
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D5 D6
2007 2008 2009 2010 2011 2012
0.0
0.1
D6
D7
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
0.2
D7
S DENMARK
2007 2008 2009 2010 2011 2012
8.0
8.5
9.0
S DENMARK D7
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
0.10
D7
D6
2007 2008 2009 2010 2011 2012
0.0
0.1
D6 D5
2007 2008 2009 2010 2011 2012
-0.025
0.000
0.025
0.050
D5
D4
2007 2008 2009 2010 2011 2012
0.00
0.05
D4 D3
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D3
D2
2007 2008 2009 2010 2011 2012
-0.025
0.000
0.025
0.050
D2 D1
2007 2008 2009 2010 2011 2012
-0.025
0.000
0.025
0.050
D1

36


Fig 6 : Multi-resolution of stock market returns (Logarithm of FINLAND, between October 25, 2006 and October 18, 2011 on a daily
basis). The top right cell represents the trend (S7) and the original oil price curve

Fig 7 : Multi-resolution of stock market returns (Logarithm of FRANCE, between October 25, 2006 and October 18, 2011 on a daily
basis). The top right cell represents the trend (S7) and the original oil price curve
S FINLAND
2007 2008 2009 2010 2011 2012
6.0
6.5
7.0
S FINLAND
D7
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D7
D6
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D6 D5
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D5
D4
2007 2008 2009 2010 2011 2012
0.0
0.1
D4 D3
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D3
D2
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D2 D1
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D1
S FRANCE
2007 2008 2009 2010 2011 2012
7.0
7.5
8.0
S FRANCE
D6
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D6
D7
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D7
D4
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D4
D5
2007 2008 2009 2010 2011 2012
0.0
0.1
D5
D2
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
0.10
D2
D3
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
0.10
D3
D1
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D1

37


Fig 8 : Multi-resolution of stock market returns (Logarithm of GERMANY, between October 25, 2006 and October 18, 2011 on a daily
basis). The top right cell represents the trend (S7) and the original oil price curve.

Fig 9 : Multi-resolution of stock market returns (Logarithm of NORWAY, between October 25, 2006 and October 18, 2011 on a daily
basis). The top right cell represents the trend (S7) and the original oil price curve.
S GERMANY
2007 2008 2009 2010 2011 2012
7.0
7.5
8.0
S GERMANY D7
2007 2008 2009 2010 2011 2012
-0.05
0.05
D7
D6
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D6 D5
2007 2008 2009 2010 2011 2012
0.00
0.05
D5
D4
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D4 D3
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D3
D2
2007 2008 2009 2010 2011 2012
-0.025
0.000
0.025
0.050
D2 D1
2007 2008 2009 2010 2011 2012
-0.025
0.000
0.025
0.050
D1
S NORWAY
2007 2008 2009 2010 2011 2012
7.5
8.0
8.5
S NORWAY D7
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
0.2
D7
D6
2007 2008 2009 2010 2011 2012
-0.1
0.0
0.1
D6 D5
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D5
D4
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
0.10
D4 D3
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D3
D2
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D2 D1
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D1

38


Fig 10 : Multi-resolution of stock market returns (Logarithm of UK, between October 25, 2006 and October 18, 2011 on a daily basis).
The top right cell represents the trend (S7) and the original oil price curve.
6.2 Wavelet estimated variance

Fig 11 : Wavelet variance of the time series at all 7 levels with a 95% confidence interval. Time scales are represented in abscissa.


S UK
2007 2008 2009 2010 2011 2012
6.5
7.0
7.5
S UK
D7
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D7
D6
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
0.10
D6 D5
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D5
D4
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D4 D3
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D3
D2
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
D2 D1
2007 2008 2009 2010 2011 2012
-0.05
0.00
0.05
0.10
D1

39

As mentioned above, the method used to decompose the time series in this thesis is the
Maximum Overlap Discrete Wavelet Transform (MODWT), as it allows us to use a sample
which size is not necessarily a multiple of a power of 2, and because its wavelet variance
estimator is asymptotically more efficient than the one based on the DWT. Using an MODWT
variance analysis, with an LA(8) wavelet and 7 levels of decomposition, we obtain the
variance decomposition of our seven variables represented in Figs. 11. We can observe in
Figs. 11 that the variance of 7 variables rises when the level increases. This is not surprising
when considering Fig. 4-10, showing that the higher the level of decomposition, the larger the
dispersion of the wavelet details around their average. There seems to be an almost linear
relationship between the wavelet variance of the oil price variable and the wavelet scale,
suggesting a possible long term dependent structure in the oil price series (Elder and Serletis,
2008; Choi and Hammoudeh, 2009)
6.3 Wavelet correlation
When analysing the relationship between oil price and stock price, one major concern is
whether one is leading the other. To investigate this issue, Fig. 12 shows the wavelet
correlation between the two variables at all seven levels corresponding to 6 pairs ( France
Brent, Filand-Brent, Denmark-Brent, Gemany-Brent, Norway-Brent, UK Brent) . Regarding
Fig. 12, we can see that.
- Each country has a different correlation between oil price and stock price
- Most of the correlations between the two variables appear to be significant at level 6 except
for correlations Brent Denmark and Brent Norway are always positive ( Denmark and
Norway are net oil-exporting countries)
-The correlations between the two variables (France Brent and UK-Brent, Germany-Brent)
only appear to be significant at level 6, with negative values. At the other levels, the
correlation between the two variables is not significantly different from zero or positive. In
fact, it is suitable to France & UK are both oil-exporting and oil-importing countries and
Germany is oil-importing country
- The correlations between the two variables (Brent-Filand) is negative or is not significantly
different from zero. This is consistent with the oil-importing country.

40


Fig 12 : Wavelet correlation of BRENT and Countries Indices

7. Discussions and concluding remarks
While most previous studies rely on a VAR-type methodology to tackle the issue of the
stock market impact of oil price disruptions, this thesis uses a more innovative approach based
on the wavelet theory. This decomposition enables to decompose a signal into various time
scales without losing time related information and to capture the various time scales at which
the factors that influence the oil price operate. It is useful in revealing that the nature of the oil
price stock market relationship is not the same through all time scales, and that a multi-scale
analysis can help unravel the changes that can occur in such relationships when various times
cales are considered. Our main findings may be summarized as follows. First, In a country,
each time scale has a corresponsing dynamic of return. Second, the higher variance when the
level increases, it means that if bigger horizon is higher risk. Third, investigating the
relationship between the oil price and national stock markets indicators proxied by the MSCI
index, we show that at low wavelet levels (high frequency cycles), both the oil price and the
MSCI index seem to entertain a feedback relationship, where they are both leading and
lagging each other. At larger wavelet levels however, only the MSCI happens to be leading
Correlation BRENT-DENMARK
1 2 3 4 5 6 7 8
0.0
0.5
1.0
Correlation BRENT-DENMARK Correlation BRENT-FINLAND
0 1 2 3 4 5 6 7 8
-0.5
0.0
0.5
Correlation BRENT-FINLAND
Correlation BRENT-FRANCE
0 1 2 3 4 5 6 7 8
-0.5
0.0
0.5
1.0
Correlation BRENT-FRANCE Correlation BRENT-GERMANY
0 1 2 3 4 5 6 7 8
-0.5
0.0
0.5
1.0
Correlation BRENT-GERMANY
Correlation BRENT-NORWAY
0 1 2 3 4 5 6 7 8
0.0
0.5
1.0
Correlation BRENT-NORWAY Correlation BRENT-UK
0 1 2 3 4 5 6 7 8
-0.5
0.0
0.5
1.0
Correlation BRENT-UK

41

the oil price with a positive correlation. And this relationship is different corresponding each
coutry. So, the investor should adjust their portfolios at different countries.
A possible extension of this thesis is to investigate the long memory property of energy
prices through a wavelet approach. In particular, relying on the Discrete Wavelet Transform
(DWT) seems to be a promising way to improve the performance of usual estimates of the
fractional difference parameter of long memory processes. Indeed, the DWT provides a
decomposition of any given signal into orthogonal components corresponding to specific time
scales. This is this ability to decorrelate time series that makes DWT so relevant to analyse
long memory processes, and which could be applied to analyse energy prices. The second,
base on time scale we can built suitable invesment portfolios for each country. Third, from
wavelet composition we can find the volatility at any time.


















42

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