The crude oil market has a dominant impact on the total connectedness of the crude oil currency-implied volatility relationship, suggesting that crude oil affects currencies more than currencies affect crude oil during oil price volatilities. However, during the crude oil crisis periods, the dynamics are reversed, with crude having more of an effect. Additionally, the pairwise directional network connectedness between the currency pairs reveals that United States Dollar (USD) is more sensitive to the crude price fluctuation than other major currency pairs and is one major currency that passes idiosyncratic shocks to other currency pairs (Singh et al. 2018).
The foreign-exchange market has witnessed strong upheavals in the recent past with staggering shifts observed in currencies such as the US Dollar, Canadian Dollar, Russian Ruble and Swiss Franc. The shifts in exchange rate volatility have proved costly for many in the market. The volatility in exchange rates has put business operations at risk of affecting the dollar value of companies, assets, and liabilities denominated in foreign currencies. Additionally, the volatility of the exchange rates has forced some central banks to intervene and stabilise the overall macroeconomic environment. However, such active involvement hampers the basic idea of the cross-border free flow of goods and services. Instead, it has become increasingly important to identify the factors responsible for making the foreign exchange market volatile. The falling and rising prices of commodities have been cited as among the primary reasons for fluctuations in the exchange rate.
One such commodity impacting import/export dynamics, thus affecting the balance of payments for many countries such as Guyana, is crude oil. The trading of crude oil has evolved significantly to the extent that the crude oil price is now considered an asset price and influences the macroeconomic fundamentals of both exporting and importing countries (Bouri 2015). Crude oil’s US Dollar connection, popularly known as the ‘Petrodollar’, generates volatility in major forex pairs such as EURUSD, USDJPY, USDCAD, AUDUSD, GBPUSD, USDCHF, and NZDUSD. The Stampede has a knock-on, if not a direct, effect on other forex crosses pairs, such as EURGBP and EURJPY.
Currency pair trading and crude oil trading are subject to their own set of market risks that have an effect directly or indirectly. The factors that constitute a market risk for crude also act as a source of market risk for the exchange rate market as well. The feedback mechanism between crude oil and currencies has made the crude-currency connectedness dynamics more vigorous. The crude currency shocks spillover dynamics includes several transmission channels, such as global economic conditions, demand and supply, monetary policy, inflation and deflation, etc. The shock intensity and direction depend on the relative macroeconomic vulnerability to the ‘Petrodollar’ and global trade finance. Historically, oil price and exchange rates are inversely related as their volatility drive market sentiments and are capable of influencing both the ‘petrodollar rent income’ and ‘oil subsidies’ in oil-exporting and oil-importing countries, respectively. It has been observed recently that positive correlations between crude and currencies that trace their roots from the inverse relationship of crude and US Dollar has been phased out. Thus, correlation can be incomplete because it does not account for how risk from crude oil translates to currencies and vice versa.
Crude oil price volatility transmits shock to the exchange rate primarily via three main channels:
- The terms of trade
- Wealth effects, and
- Portfolio reallocation
The terms of the trade concept explain the interlinkages between the oil price and exchange rates (Amano and van Norden 1998). In fact, when the oil price increases, countries that have significant oil dependence in their tradable sectors, such as Guyana are largely affected. Their currency, therefore, tends to depreciate due to higher inflation in the goods as well as changes in the nominal exchange rate (Beckmann et al. 2017).
The other two channels are based on a three-country framework, and the underlying principle for the oil-exporting countries is that they experience a wealth transfer if the oil price rises (Bénassy-Quéré et al. 2007). Whereas the wealth channel has a short-run impact, the portfolio reallocation is based on medium- and long-run impacts. The oil price rise may have the following impacts:
- currencies of oil-exporting countries will appreciate, and currencies of oil-importing countries will depreciate in effective terms (Beckmann and Czudaj 2013); and
- if oil-exporting countries reinvest their revenues in dollar assets, the dollar will appreciate in the short run.
An oil price increase leads to an appreciation in the exchange rate in oil-exporting countries and depreciation in oil-importing countries, notwithstanding the fact that even dollar exchange rate fluctuations can influence crude oil prices (Reboredo 2012). Furthermore, a fall (rise) in oil prices should be rallied by the depreciation (appreciation) of currency for oil-exporting economies. However, in practice, there may be counterbalancing forces, such as intervention by the central bank, etc., which may not allow the exchange rate to move with crude oil prices (Bodenstein et al. 2012). For countries not pegged to the US dollar, the co-movement between currencies and oil price is more sensitive to the dollar and crude oil fluctuations (Coudert et al. 2011). With the increase in global trade connectedness, the major forex currency pairs are relatively more exposed to idiosyncratic shocks, which makes the crude-currency connectedness dynamics more vulnerable. A focus of major currency pairs vis-à-vis crude quantifies the amount of systematic risk that the pairs and crude transferred to each other, subject to market sentiments affecting some of the pairs and crude.
The current market sentiment is well reflected in the current price of crude and currency based on supply and demand, assuming that the market is efficient in the weakest form. However, it is interesting to note that possible future values of crude and currency prices are reflected by the implied volatility (Corrado and Miller 2005). The main idea is to explore the link between future uncertainties as it shapes the spot pricing of the underlying asset. The future uncertainty of crude reflected via implied volatility has a role in speculation in the forex market and vice versa. In general, implied volatility is seen as a proxy for systemic market risk. As with the market as a whole, implied volatility is subject to unpredictable changes. Supply and demand are a major determining factor for implied volatility. When security is in high demand, the price tends to rise, and so does implied volatility, which leads to a higher premium due to the risky nature of the derivative contracts. A study based on implied volatility tries to capture the market risk that affects a currency pair indirectly, which is explained as a proportional contribution by the market risk that affects crude directly. The same holds true when explaining the market risk affecting crude is indirectly involved via currency pair. The implied volatility serves as a proxy for the future market risk that crude pricing is vulnerable. The same set of future market uncertainty is able to affect currency pair trading. The multidirectional influence between crude oil price and exchange rates and their volatility spillover effect has a considerable impact on trading and serves as inputs for policymaking (Lizardo and Mollick 2010).
Moreover, an increase (decrease) in the price of crude oil leads to depreciation (appreciation) of the US dollar. The reason for this could be that crude oil is primarily invoiced in US dollars. Thus, the devaluation of the US dollar negatively affects the purchasing power parity of oil-exporting countries, especially if their currency is pegged with the dollar.
Further, the drivers of oil and dollar price linkages from the perspective of volatility indicate that economic activity is more affected by oil price volatility than the oil price level. A volatile market increases uncertainty in the market and compels states and multinational companies (MNCs) to postpone their investments. Therefore, instead of the price level, it is the ‘surprise’ factor in the oil price that matters more (Grisse 2010). This ‘surprise’ factor affects countries differently. Its impact is determined by the contribution of oil to energy production or consumption in that economy. While higher oil prices affect stock, market returns in the United States adversely, the effect in other advanced countries is positive (O’Neill et al. 2008). In contrast, the real price of oil is negatively attached to the variability of the exchange rate, irrespective of whether the country is oil-exporting or oil-importing (Coudert et al. 2015). It has been estimated that ceteris paribus, in the long run, a 10% increase or decrease in the oil price leads to a 5 – 7% depreciation or appreciation, respectively, in the basket of currencies linked strongly to the US dollar (Gomes 2016).
These cascading effect of the same can encourage central banks to take precautionary measures to align the prices of the dollar with the economic health of oil-importing and -exporting nations such as Guyana. This signals that the dollar and other currency pairs cannot operate in isolation. For this reason, regulators and traders need to understand why crude oil and currency prices are volatile as well as the repercussions of the same on the numerous forex pairs. Given the evolving nature of geopolitical architecture and the increasing dependence of emerging and developing countries on crude oil and global trade, it would be helpful to both policymakers as well as for industry professionals working in the oil and gas sector and the currency markets to align their strategies towards the protection of the fiscal management of the host nation.