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Spillover effect of US dollar exchange rate on oil prices

Author

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  • Zhang, Yue-Jun
  • Fan, Ying
  • Tsai, Hsien-Tang
  • Wei, Yi-Ming

Abstract

The US dollar is frequently used as the invoicing currency of international crude oil trading. Hence, the fluctuation in US dollar exchange rate is believed to underlie the volatility of crude oil price and especially its forecasting accuracy. Using econometric techniques including cointegration, VAR model, ARCH type models and a newly proposed approach to test Granger causality in risk, three spillover effects are explored, i.e., mean spillover, volatility spillover and risk spillover. Using rigorous appraisal, analysis is made of the influence of US dollar exchange rate on the international crude oil price from the perspective of market trading and several findings have been obtained. Firstly, a significant long-term equilibrium cointegrating relationship can be identified between the two markets. This suggests a crucial reason for the fluctuation in crude oil price. But interestingly, the reverse does not work. Specifically, the influence of a standard deviation disturbance of US dollar exchange rate on oil price is increased quite slowly, and reaches its highest point, 1.0088 US dollars per barrel, after 1 year or so with a slightly and steadily diminishing process afterward. This implies that the US dollar depreciation for the years under investigation was a key factor in driving up the international crude oil price. Secondly, there is apparent volatility and clustering for the two market prices, whereas their volatility spillover effect is insignificant, which reveals that their price volatility take relatively independent paths and the instant fluctuation in US dollar exchange rate will not cause significant change in the oil market. Finally, their risk spillover effect appears quite limited, hence price risk influence of US dollar exchange rate on the oil market is not necessarily emphasized too much. Put it another way, compared with the powerful oil market, the impact of US dollar exchange rate is confirmed to be relatively partial. These results indicate that the influence of US dollar exchange rate on the international crude oil market proves quite significant in the long term; however, its short-term and instant influence turns out to be quite limited, which is noteworthy to be taken into account for oil market researchers, market trading analysts and traders.

Suggested Citation

  • Zhang, Yue-Jun & Fan, Ying & Tsai, Hsien-Tang & Wei, Yi-Ming, 2008. "Spillover effect of US dollar exchange rate on oil prices," Journal of Policy Modeling, Elsevier, vol. 30(6), pages 973-991.
  • Handle: RePEc:eee:jpolmo:v:30:y:2008:i:6:p:973-991
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