Detection of structural regimes and analyzing the impact of crude oil market on Canadian stock market: Markov regime-switching approach

Abstract

Purpose

This study aims to analyze the impact of the crude oil market on the Toronto Stock Exchange Index (TSX).

Design/methodology/approach

The focus is on detecting nonlinear relationship based on monthly data from 1970 to 2021 using Markov-switching vector auto regression (VAR) model.

Findings

The results indicate that TSX return contains two regimes: positive return (Regime 1), when growth rate of stock index is positive; and negative return (Regime 2), when growth rate of stock index is negative. Moreover, Regime 1 is more volatile than Regime 2. The findings also show the crude oil market has a negative effect on the stock market in Regime 1, while it has a positive effect on the stock market in Regime 2. In addition, the authors can see this effect in Regime 1 more significantly in comparison to Regime 2. Furthermore, two-period lag of oil price decreases stock return in Regime 1, while it increases stock return in Regime 2.

Originality/value

This study aims to address the effect of oil market fluctuation on TSX index using Markov-switching approach and capture the nonlinearities between them. To the best of the author’s knowledge, this is the first study to assess the effect of the oil market on TSX in different regimes using Markov-switching VAR model. Because Canada is the sixth-largest producer and exporter of oil in the world as well as the TSX as the Canada’s main stock exchange is the tenth-largest stock exchange in the world by market capitalization, this paper’s framework to analyze a nonlinear relationship between oil market and the stock market of Canada helps stock market players like policymakers, institutional investors and private investors to get a better understanding of the real world.

Citation

Mahmoudi, M. and Ghaneei, H. (2022), "Detection of structural regimes and analyzing the impact of crude oil market on Canadian stock market: Markov regime-switching approach", Studies in Economics and Finance, Vol. 39 No. 4, pp. 722-734. https://doi.org/10.1108/SEF-09-2021-0352