How Do Oil Shocks Affect Stock Market Risk

Several recent researches have documented some predictability of crude oil prices changes on stock market returns. Using a two-consumption good asset pricing model, I illustrate a mechanism for oil shocks to translate into stock market risk. Using U.S. data, I find supporting evidence that oil price changes have significant effects on the second moments of the stock market returns. Furthermore, I find remarkable time-variation in both the empirical conditional volatilities and correlations. Based on the estimated second moments, I construct the time-varying empirical risk premia. My empirical results combined with the theory shed light on a risk-based explanation for the observed predictability. A preliminary test of this explanation points to the need for more sophisticated modeling of the interactions between oil and stock market risk.