Oil price effect on sectoral stock returns: A conditional covariance and correlation approach for Mexico

Abstract

This paper analyzes the relationship between the volatility of oil price and selected sectoral stock returns in Mexico (industrials, materials, financials and consumer discretionary) by implementing a Diagonal VECH-type bivariate GARCH model in order to estimate conditional covariances and correlations. The econometric results suggest that there exists a statistically significant relationship between sector indices, as well as between Mexico’s aggregate stock exchange returns, and variations in oil prices. Conditional correlations suggest that during most of the analyzed period, the relationship between oil price fluctuations and sectoral stock returns is positive. The recommendation, supported by these results, is that investors should take into consideration the interaction between the analyzed variables in order to generate more robust risk-hedge strategies. An important limitation for this work is information availability at sector level in the country. The original contribution of this paper lies mainly in the analysis of the influence of oil prices over sectoral indices of the Mexican Stock Exchange. These results provide more support to the current that suggests that a price increase in oil has a direct spillover effect on stock market performance.