The economic value of co-movement between oil price and exchange rate using copula-based GARCH models

Abstract

The US dollar is used as the primary currency of international crude oil trading; as such, the recent substantial depreciation in the US dollar has resulted in a corresponding increase in crude oil prices. In addition, oil price and exchange-rate returns have been shown to be skewed and leptokurtic, and to exhibit an asymmetric or tail dependence structure. Therefore, this study proposes dynamic copula-based GARCH models to explore the dependence structure between the oil price and the US dollar exchange rate. More importantly, an asset-allocation strategy is implemented to evaluate economic value and confirm the efficiency of the copula-based GARCH models. In terms of out-of-sample forecasting performance, a dynamic strategy based on the CGARCH model with the Student-t copula exhibits greater economic benefits than static and other dynamic strategies. In addition, the positive feedback trading activities are statistically significant within the oil market, but this information does not enhance the economic benefits from the perspective of an asset-allocation decision. Finally, a more risk-averse investor generates a higher fee for switching from a static strategy to a dynamic strategy based on copula-based GARCH models. (C) 2011 Elsevier B.V. All rights reserved.