The following are theoretical transmitting channels between oil pricesand stock markets, namely stock valuation, monetary,    Literature review will begin by investigating how oil prices candirectly influence stock markets.   Stock valuation is the process of calculating the total value of acompany’s shares.

Huang et al (1996)suggest that stock prices reflect the discounted future cash flows of a particularstock. Oberndorfer (2009) studies how the changes in oil price could alter acompany’s future cash flows. The study reveals that   Filis et al (2011) study the correlationbetween stock markets and oil prices in oil-importing and oil-exportingcountries. The study shows that for any oil-consuming company, when oil is oneof their major production factors, resultantly high oil price would result inhigh production costs, and eventually would reduce profit and future cashflows. As for oil-producing companies, high oil price would result in highprofit margins and cash flows.

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Theoretically, the study gives an indication thatduring any high oil price period, oil-consumers should have a decliningbehaviour in stock markets, while an inclining behaviour for oil-producers.    Basher and Sadorsky (2006) explains that, as a result of high oil price,the high production costs would be transferred to consumers, thereforeresulting in an increase in both retail prices and inflation. In response toincreasing inflation pressures, the monetary policymakers will be expected toincrease short-term interest rates.

Theoretically, this would lead to anincrease in borrowing discount rates for any future company investments,therefore increasing the company’s borrowing costs. When borrowing costsincreased, this will result in reduced future cash flows and fewer positive netpresent value (NPV) projects. For this reason, stock prices could decrease invalue. But the study notes that the effects would be determined by monetaryauthority’s credibility to contain inflation. If monetary authority’scredibility is high, inflation should not be unstable, despite high oil price.

 Additionally, studies by Hamilton (1983) and Hamilton (2003) both claimthat oil price fluctuations affect aggregate output. Because of an increase inretail prices as a result of high production costs, there is a tendency forhigh oil price to reduce households’ discretionary income. Edelstein and Kilian(2009) reports that an increase in gasoline and heating oil also reducehouseholds’ discretionary income. Put succinctly from the viewpoint of Svensson(2005 and 2006), an increase in oil price will worsen the terms-of-trade for anoil-importing economy, which will result in lower income and a negative wealtheffect on consumption, and eventually lower aggregate demand. In order words,there is a tendency that the response of stock markets will be negative, as lowaggregate demand causes low profits and cash flows for companies, therefore adecrease in stock prices. However, Svensson (2005 and 2006) also explain that theseeffects are determined whether an economy is oil-importing or oil-exporting.These effects apply to oil-importing economy, but for oil-exporting economy,although the high production costs would still have an impact due to high oilprice, oil-exporting economy would profit from high income effect, because ofan increase in oil profits gained from exporting, therefore resulting in highaggregate demand and higher output. This will happen as long as high incomeeffect can offset high production costs impact.

When that happens, there shouldbe a tendency that the response of stock markets will be favourable due to theincreased output, since it would raise the company’s cash flow operating inoil-exporting economy.    Another study on oil-exporting by Farzanegan (2011) investigates the oilrevenue shocks and government spending behaviour in Iran. The result of anincrease in oil price means a transfer of wealth from oil-importing tooil-exporting countries. This will enable oil-exporting countries to increasegovernment spending. This can stimulate additional economic activity, which isa principle known as the “Fiscal Multiplier” and it should beconsidered, because when the government spends a lot on infrastructure, forinstance, this leads to demand for goods required to produce the infrastructure,therefore private companies will expand to meet this demand and new jobs willbe created.

In this process, household spending increases therefore privatecompanies’ profit and cash flow also increases. This will cause the stockprices to increase and the stock market to exhibit a bullish behaviour. On thecontrary, the opposite will happen when the government borrows to finance itsdeficits, as it competes with private borrowers and bids up the interest rate,which is a principle knows as “Crowding Out Effect” and it should beconsidered as well.

 Apart from all above, Brow and Yücel (2002) suggest that an increase in oilprice will cause higher uncertainty of oil in the economy, due to the aforementionedeffects of inflation, output, household expenditure and discount rate. Brow andYücel (2002) claims that uncertainty will decrease the company’s demand forrisky, irrecoverable investments, which in time, will decrease expected cashflows. Also, Edelstein and Kilian (2009) states that an increase in uncertaintyof future oil prices would increase motivation for households to save upinstead of consuming.