Oil price volatility and sectoral returns uncertainties: evidence from a threshold based approach for the Australian equity market

This paper examines the existence of a non-linear relationship between oil price volatility and
equity market uncertainty. The study specifically analyses the pattern of effects of oil price
volatility on the broader equity market as well as the sectoral equity returns volatility within
Australian Economy. We use a logistic transition based autoregressive model (LSTR) developed
by Teräsvirta and Anderson (1992) and Teräsvirta, (1994). We find that the hypothesis of
linearity between oil price volatility and equity market uncertainty is rejected for six out of 10
sectors of the Australian economy. The retention of LSTR model suggests that the oil return
volatility has high and low regimes that affect equity markets differently across the sectors. The
transition functions suggest that switching of oil price volatility from low to high regime is
abrupt for consumer discretion, financial and material sectors while such transition is smooth
for consumer staple, energy, and industrial sectors. The results also show that some sectors are
quicker in responding to heightened volatility. From the VAR framework, the impulse response
functions show that a one period increase or a shock in oil price volatility raises volatility of
equity in consumer discretion, consumer staple, finance, industry, telecom and consumer staple
sectors. Of these, equity volatility in industries and financial sectors seem to exhibit a prolonged
positive response following the oil price volatility shock. Also, equity volatility of industries
seems to rise by much larger proportion compared to the equity volatility response of other
sectors. These findings are helpful as a guide for sectoral rotation strategies. In view of the
increased volatility of oil prices due to a negative impact of oil price shock and the resultant
surge of uncertainty, Australian firms could formulate their short and long run investment plans
based on volatility threshold level. Firms in consumer discretion, financial and industrial sector
could consider postponement of investment if the volatility in oil price exceeds certain threshold.
Also, firms in the consumer staple, energy and materials industry need to make prudent business
decisions in situations where oil price volatility falls within the threshold range as identified by
the LSTR2 models. Based on the findings, there is a need for public policy formulation to reduce
the adverse impacts of increased oil price uncertainties on the Australian economy during
periods of unforeseen random events including depressions and crises.