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Review of Managerial Science

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11.09.2020 | Original Paper

The impact of oil price and exchange rate on momentum strategy profits in stock market: evidence from oil-rich developing countries

verfasst von: Mehdi Zolfaghari, Bahram Sahabi

Erschienen in: Review of Managerial Science | Ausgabe 7/2021

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Abstract

The existing literature is still inconclusive on whether momentum exists and whether momentum strategy profits are affected by macroeconomic variables. The aim of the present study is two-fold. First, we examined the existence of the momentum by studying the strategy profits in six oil-rich developing countries in Middle East including Iran, Saudi Arabia, Bahrain, Qatar, the United Arab Emirates, and Kuwait using the double-sort strategies. Our findings show that there is a momentum profit over short-, mid- and long-term periods in all countries. After selecting the best combinations of information sets and holding lengths for each country, by adding the oil price and the exchange rate, and adjusting the models proposed by Chordia and Shivakumar (J Finance 57:985–1019, 2002) and Kim et al. (J Bank Finance 49:191–215, 2014) on the characteristics of oil-rich developing countries, we estimated the impact of macroeconomic variables on the expected momentum profits through a two-state Markov regime switching model under different distributions. The findings indicate that the momentum strategy profits can be explained by a set of lagged macroeconomic variables, especially oil prices and exchange rate. The results show that the winner portfolio has a greater sensitivity to macroeconomic variables than does the loser portfolio in both the expansion and recession states. It is also indicated that both the winner and the loser stocks are riskier in the expansion periods than recession periods. The results indicate that the returns on momentum portfolios react asymmetrically to economic conditions in the recession and expansion states.

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Small minus big.

High minus low.

Default spread (DEF) is defined as the difference between yields on Baa-rated corporate bonds and 10-year Treasury bonds.

In fact, one of the main differences between developing markets and developed markets is the absence of a comprehensive rating system for corporate bonds in developing markets. For this reason, there is no strong debt market (bond market) in these countries. Therefore, many companies are unwilling to issue corporate bonds. On the other hand, due to the larger share of the government in these economies, there are a large number of government bonds whose yields are close to the formal interest rate by commercial banks. In other developing countries where there are debt markets, due to the stabilization policies of central banks, the yields on corporate bonds are close to the Treasury bond yields.

Oil can affect stock market dynamics via different channels. At the firm level, oil prices can affect costs and growth expectations, which then affect stock values. At the consumer level, oil prices can affect consumer spending via its effect on disposable income, thus, influencing demand for goods that drive firm-level revenues and growth rates (Bencivenga et al. 2012). Since the market value of petroleum industry in the six mentioned countries is almost more than 25% of the market capitalization, undoubtedly, oil price is one of the major affecting variables on stock market fluctuations in these countries (Nejad et al. 2016; Basher et al. 2018; Mensi 2019).

The exchange rate fluctuations have a major role in stock market behavior in a country. Currency depreciation is said to affect share prices in either direction. Obviously, export oriented firms which gain international competitiveness and thus export more, are expected to experience high profit levels and enjoy an increase in their share prices. On the other hand, domestic firms that are not export oriented will face an increase in the cost of imported inputs and perhaps experience a decline in their profit margins. Hence, the share prices of such firms are expected to be fall. Moreover, in addition to petroleum companies, many listed companies in the six mentioned countries (such as mineral and pharmaceutical industries) have a high trade volume relation with the rest of world. Also, from a behavioral perspective, one can argue that exchange rate fluctuations can affect investors’ sentiment. Such an effect on investors’ sentiment, in turn, may contribute to misprice the stock market in the form of stock market anomalies (Chen et al. 2017).

It has been widely used in previous studies.

Since we focused on the stock market of six developing countries, we have limited access to Fama and French (1992) risk factors in their stock markets. So, we had to give them up.

\( \rho \) and \( q \) are probabilities where the volatility remains in the same regime.

Unlike most previous studies, we take into account the transaction costs in the calculation of the excess returns. Because there is a debate about whether plain momentum per se is economically exploitable after transaction costs. For example, Lesmond et al. (2004) indicated costs indirectly from observed trading behavior and found that momentum is not exploitable.

Middle group is divided into three categories including portfolios 2 to 4.

According to Barroso and Santa-Clara (2015), Wang and Xu (2015), and Daniel and Moskowitz (2016), volatility is one of the important variables which can sometime plays a major role in trading strategies. Drawn upon a recent study by Yang et al (2018), we used the “idiosyncratic volatility” in structure of double-sort strategies once and used the “turnover ratio” once more. Based on the t-statistics and the mean excess returns of momentum strategies portfolios, the strategy with the “turnover ratio” outperforms the strategy with the “idiosyncratic volatility”. But due to the word count limitation of the paper, in this section we used the strategy with the “turnover ratio”.

\( Sharpe\;Ratio = \frac{{r_{p} - r_{f} }}{{\sigma_{p} }} \)

where \( r_{p} \) and \( r_{f} \) are return of portfolio and risk-free rate, respectively. \( \sigma_{p} \) is standard deviation of the portfolio’s excess return.

The momentum strategy profits can be explained by oil prices, exchange rate and other macroeconomic variables’ fluctuations.

We add oil prices reflecting oil revenues as another variable to the model.

In some developing countries, the changes in these yields do not happen along with the changes in the real economic condition.

Instead of the growth in monetary base, we also included the inflation rate. However, the results were qualitatively similar.

We also, compared the predictive power of MRS model and OLS regression. The results showed that the MRS has a much lower prediction error than OLS for all stock markets.

Since the selected countries are Muslim, we estimated the month of Ramadan for all countries, but the coefficients were not significant. So we avoided presenting it in Table 8.

We mean an increase in the stock price of most companies.

Adding dummy variables to the model removes (or inactivates) discarded points, which leads to strengthening the fitness of the regression model and raise the coefficients of the exogenous variables.

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Titel: The impact of oil price and exchange rate on momentum strategy profits in stock market: evidence from oil-rich developing countries
verfasst von: Mehdi Zolfaghari
Bahram Sahabi
Publikationsdatum: 11.09.2020
Verlag: Springer Berlin Heidelberg
Erschienen in: Review of Managerial Science / Ausgabe 7/2021
Print ISSN: 1863-6683
Elektronische ISSN: 1863-6691
DOI: https://doi.org/10.1007/s11846-020-00413-0

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