Can the skewness of oil returns affect stock returns? Evidence from China's A-Share markets

Crude oil is an influential commodity in the real economy and stock markets of the world. However, the literature focuses exclusively on using the first or second moment of oil prices and ignores the information content in higher order moments. Our paper addresses this gap by investigating the relationship between the skewness of oil returns and expected stock returns in China's A-share market. We find that the relationship between the skewness of oil returns and expected stock returns is significantly negative. This finding is robust even after considering firm characteristics, lagged oil returns, different energy dependencies, and changes in the supply and demand of oil, and is sustained across industries. This negative relationship can be interpreted as investors' preference for skewness. Investors tend to overweight the tails of positively skewed oil returns to capture lottery-like payoffs, leading to net long positions and overpricing, which in turn lead to negative average returns. We also find that there are structural patterns for the relationship between the skewness of oil returns and expected stock returns. The negative relationship only exists in falling stock markets and changes under extremely low volatility.