Econometrics of Crude Oil Markets

Tatyana Gileva
Supervisor: Dominique Gu´gan e Universit´ Paris 1 Panth´on-Sorbonne e e

A thesis submitted for the degree of Master in Economics 2010 June

Abstract

This project investigates the dynamics of oil prices (Brent and WTI crude oil markets) and their volatilities. Through application of different econometrical tools we examine the behavior of crude oil prices and the fundamental factors contributing to this process. Then performance of different models of oil markets will be compared. Keywords: Oil markets - Crude oil volatility - GARCH modelling - Oil fundamentals.

Contents
List of Figures List of Tables 1 Introduction 1.1 1.2 1.3 Motivation and background . . . . . . . . . . . . . . . . . . . . . . . . . Objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Literature review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.3.1 1.3.2 1.3.3 1.3.4 Crude oil markets and their impact on macroeconomy . . . . . . Oil price volatility . . . . . . . . . . . . . . . . . . . . . . . . . . Modelling crude oil prices and their volatility . . . . . . . . . . . Determining fundamental factors . . . . . . . . . . . . . . . . . . v vi 1 1 2 3 3 3 4 6 7 7 7 9 11 13 13 14 14 14 15 15 16

2 Methodology of time series analysis 2.1 Modelling financial time series . . . . . . . . . . . . . . . . . . . . . . . . 2.1.1 2.1.2 2.1.3 2.1.4 2.1.5 2.1.6 2.2 2.2.1 ARMA model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ARCH model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . GARCH Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . EGARCH Model . . . . . . . . . . . . . . . . . . . . . . . . . . . GJR-GARCH Model . . . . . . . . . . . . . . . . . . . . . . . . . APARCH Model . . . . . . . . . . . . . . . . . . . . . . . . . . . Choice and validation of time series model . . . . . . . . . . . . . 2.2.1.1 2.2.1.2 2.2.2 Jarque-Bera test . . . . . . . . . . . . . . . . . . . . . . Ljung-Box test . . . . . . . . . . . . . . . . . . . . . . .

General methodology and statistical tools . . . . . . . . . . . . . . . . .

Choice of time series model based on information criteria . . . .

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CONTENTS

2.2.3

Choice of time series model based on forecasting performance . . 2.2.3.1 2.2.3.2 Forecast performance measures based on loss function . Diebold-Mariano test . . . . . . . . . . . . . . . . . . .

16 16 17 19 19 23 25 25 27 29 29 31 32 34 34 37 40 40 42 44 44 45 47 48 49

3 Empirical Results 3.1 3.2 3.3 Properties of the data set . . . . . . . . . . . . . . . . . . . . . . . . . . GARCH modelling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Results of estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3.1 3.3.2 3.4 3.4.1 3.4.2 3.5 WTI crude oil market . . . . . . . . . . . . . . . . . . . . . . . . Brent crude oil market . . . . . . . . . . . . . . . . . . . . . . . . Forecast performance measures . . . . . . . . . . . . . . . . . . . Diebold-Mariano test . . . . . . . . . . . . . . . . . . . . . . . . .

Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 Determining fundamental factors 4.1 4.2 4.3 Data set and choice of factors . . . . . . . . . . . . . . . . . . . . . . . . Correlations and linear regression . . . . . . . . . . . . . . . . . . . . . . Principal component analysis . . . . . . . . . . . . . . . . . . . . . . . . 4.3.1 4.3.2 4.4 4.4.1 4.4.2 4.5 Theoretical background . . . . . . . . . . . . . . . . . . . . . . . Empirical results . . . . . . . . . . . . . . . . . . . . . . . . . . . Forecasting returns series . . . . . . . . . . . . . . . . . . . . . . Forecasting volatility . . . . . . . . . . . . . . . . . . . . . . . . .

Forecasting and comparison . . . . . . . . . . . . . . . . . . . . . . . . .

Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5 Concluding remarks Bibliography

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List of Figures
3.1 3.2 3.3 3.4 3.5 4.1 Dynamics of daily prices and returns of West Texas Intermediate and Brent crude oil markets (US Dollar/Barrel) . . . . . . . . . . . . . . . . Histograms and density plots of crude oil prices and returns . . . . . . . Q-Q plots of crude oil prices and returns . . . . . . . . . . . . . . . . . . Autocorrelation and Partial Autocorrelation functions of WTI returns . Autocorrelation and Partial Autocorrelation functions of Brent returns . Plot of factors in PC1-PC2 coordinate system . . . . . . . . . . . . . . . 20 22 22 23 23 43

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. . .2 4. . . . . . . . . .6 4. . . . . . Volatility forecasts of Brent crude oil returns. . . . .List of Tables 3. Estimation of linear regression model with the initial set of factors.3 4. . . . WTI crude oil spot prices. . . . . . . . . . . Diebold Mariano test statistics. . . Cross correlation analysis. . . . .5 3. . . 4. . . Diebold Mariano test statistics. . . . . . . . . . . . . Principal Component Analysis .3 3. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 3. . . . . . . . WTI crude oil spot returns. . . . . . . . . Volatility forecasts of WTI crude oil returns. . . . . . Forecast of returns series. . . . . . . . . . . . . . . . . . . . . . . . . . . WTI returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . WTI crude oil returns. . . . . .1 3. . . . . . . . . . .6 Descriptive Statistics of WTI and Brent prices and returns series. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 3. . . . . . . Results of comparison. . . . Estimation of linear regression model with the reduced set of fundamental factors. . . . . . . . Forecast performance measures. . . . . . . . . . . . Estimation of linear regression model with the reduced set of fundamental factors. . . . Estimation results of four conditional heteroskedasticity models. . . . .7 4. . . . . . . . . . . . Brent returns. . . . . . . . . . . . . . . . . . . .1 4. . 44 45 43 40 42 39 38 39 32 31 30 28 26 21 vi . . . . . . . . . . . . . WTI crude oil spot price. . . . . . . . . . .5 4. . . . . . . . . . . . . .8 List of variables used in the analysis of fundamental factors affecting WTI crude oil prices. . . . . . . . . . . . . . . . . . . . . . . . . . . Volatility forecasts of WTI and Brent crude oil returns. . . Estimation of linear regression model with the initial set of factors. . . . . . . . . . . . . . . .4 4. . . . . Estimation results of four conditional heteroskedasticity models. . . . . . . . .

10 Modelling weekly WTI returns: mean equation ARMA(1. . . . . . . . . . . . .1) with external regressors. . . . . . . Forecast performance measures . . . . . . . . . . 45 4. . . . . . . . . . 4.9 Modelling weekly WTI returns: mean equation ARMA(1. . . . . . . . . . . four models of conditional variance. . . . . . . . 46 46 vii . . . . . . .LIST OF TABLES 4. . . . . . . .1) with external regressors. .11 Modelling weekly WTI returns: mean equation ARMA(1. . . . . . four models of conditional variance. . . . . Results of estimation . . . . . . . . Forecast performance measures . .1) without external regressors. .

In particular. the economical instability may be observed for both oil-exporting and oil-importing countries.1 Introduction 1. We specify some of them. In such economies oil price fluctuations not only affect the government budget considerably. 2. as a result. High volatility of oil prices creates uncertainty. For instance. daily changes in oil price volatility impact daily stock prices of oil companies and play an 1 . In the last several years crude oil prices have presented large variations . resource-based economies or economies that extremely depend on oil are characterized by significant uncertainty and high volatility of exports and therefore government revenues.they have steadily risen from about 25 dollars a barrel in August 2003 to over 130 dollars a barrel in May 2008 and then dramatically dropped down during the crisis of 2008. predicting the future price of this commodity and managing the risks associated with oil prices became crucial for governments and businesses in several different respects.1 Motivation and background Crude oil is a commodity of great importance and one of the most significant production factors in many economies. but also have strong effects on stock markets and macroeconomic variables. Considerable fluctuations in oil prices often have great impacts on economies in general. Variation of oil prices significantly affects financial markets. 1. It is mainly because of the key role of oil in the world economy. the result is recession in oil-consuming countries. Several features of oil market seem well known. higher crude oil prices contribute to inflation. In particular.

The results should be useful to members of oil industries. industrial consumers. The decision making process on each of the levels described above highly depends upon behavior of oil prices. Understanding oil price evolution and its forecasting is very important for oil industry. 1. On the other hand. 2 . Given the effects of oil price volatility and the uncertainty. Producers make oil price forecasts for general purposes of strategic planning and for specific purposes of evaluating investment decisions related to resource exploration. interest rates. etc. there is considerable empirical evidence causally linking oil price changes with stock market variables including stock returns. reserve development and production. make these forecasts for the same kinds of reasons . 3. such as chemical companies.1. Moreover. performance of several models of volatility for forecasting purposes will be compared.2 Objectives The aim of this project is to investigate the dynamics and volatility of prices of West Texas Intermediate and Brent crude oil markets.oil is an important input cost that can affect investment decisions. Then.2 Objectives important role in pricing various financial instruments based on crude oil. real exchange rates. which is accompanied by these price movements. we conclude that there is a great need for oil price volatility measuring and consecutive risk quantification. Accurate price forecasting can therefore help reduce portfolio risks. governments and agents of financial markets who need to be able to understand and forecast oil price movements in these markets. Through application of econometrics tools we will examine on the one hand the behavior of crude oil prices and on the other hand the fundamental factors contributing to their variation. A price forecast is the foundation for determining a firm’s risk in managing their oil supply and their forward contracts for oil trades.

3 Literature review Recent studies of crude oil markets are covering a number of different areas and issues and examine the characteristics of these markets in various respects. strong upward drift and were concomitant with underlying fundamentals of oil markets and world economy (Askari and Krichene. Lee et al.3. 1. Many empirical studies show evidence that time series of crude oil prices. post 3 . high intensity jumps.1 Crude oil markets and their impact on macroeconomy Along with other issues. 2008). Tabak and Cajueiro (2007) analyze the efficiency of crude oil markets (Brent and West Texas Intermediate). likewise other financial time series.3 Literature review 1. For example. Concerning the most recent time period mentioned in different studies. volatility clustering. asymmetry and mean reverse (Morana. 2001. (2005) studied the asymmetry of oil price shocks on economic activities.1. (1995) examines an impact of different oil shocks on real GNP and concludes that positive shocks have a powerful effect on growth while negative shocks do not. Chen and Chen (2007) examined the relationship between oil prices and real exchange rates in G7 countries using panel analysis. In Green and Mork (1991) generalized method of moments estimation technique is used for the purpose of analyzing efficiency.3. are characterized by fat tail distribution. Huang et al. 1.2 Oil price volatility Why is it important to model oil price volatility? First. Uri (1998) focuses on the issue whether price of crude oil affects the employment rates. oil price dynamics during 2002-2006 have been characterized by high volatility. 2007). concluding that oil prices have a negative impact.S. considerable fluctuations in oil prices often have great impacts on the economy. Bina and Vo. describe the long-range dependence in both crude oil prices and volatility and conclude that the markets have become more efficient over time. Another area of research is efficiency of crude oil markets. most U. the relationship between oil price volatility and macroeconomy is of a great interest. The impact of oil prices on economic growth was analyzed by Ferderer (1996). In one of the recent studies.

the effects have been shown to be asymmetric. 2001. but low oil prices do not increase it proportionately (Sadorsky. 1999. 1996). 1. 1996. it has been proven by Regnier (2007) that oil price volatility is relatively high compared to volatility of other commodities. 1999. measuring volatility in order to analyze oil price behavior is a very important issue for both policymakers and agents in financial markets. 1996). Another area of research is dealing with the relationship between oil price volatility and stock prices. Huang et al. More generally. and natural gas over a long horizon and found that oil presented the highest degree of volatility. stock returns (Sadorsky.3. Fleming and Ostdiek.1. oil prices. Pindyck (1999) examined oil. Pindyck (1999) shows that large oil price movements increase uncertainty about future prices and thus cause delays in business investments. Thus. but there is little impact on the broad stock market. volatility plays an important role for pricing derivatives and various financial instruments. In particular. 1996). and stock prices and finds that oil price volatility does have a significant impact on stock price volatility. Huang et al. 2007). Second. In some cases. 1983). 1999. 1996).3 Literature review World War II recessions were preceded by sharp increases in crude oil prices (Hamilton. 1999). 2003) estimates vector autoregressions with monthly data on industrial production. Furthermore. i. 2007). (1996) finds that daily changes in oil price volatility do impact the daily stock prices of oil companies. and real exchange rates (Chen and Chen. Oberndorfer (2009) focuses on effects of energy market developments on the energy stock market of Eurozone. 4 . Sadorsky (1999.. Furthermore. there is considerable empirical evidence connecting oil price changes with variables including gross domestic product (Hamilton.3 Modelling crude oil prices and their volatility In several early papers standard deviation of price differences is commonly used as a measure of volatility of commodity prices (Ferderer. Ferderer.e. Ferderer. interest rates (Papapetrou. The volatility of oil prices was examined in comparison with volatility of other commodities by a number of authors (Pindyck. increasing oil price depress the economy. coal. Regnier. interest rates.

simple autoregressive models or linear regressions have shown worse results (Sadorsky. Among other recent papers. Dubai. 2006). EGARCH etc. Vo (2009) works with a concept of regime-switching stochastic volatility and explains the behavior of crude oil prices of WTI market in order to forecast their volatility. This model assumes that the conditional variance is a deterministic linear function of past squared innovations and past conditional variances. Initially. standard GARCH is used by Yang et al. it models the volatility of oil return as a stochastic volatility process whose mean is subject to shifts in regime. Kang et al.3 Literature review Recently. the autoregressive conditional heteroskedasticity (ARCH) model was introduced by Engle (1982) and then this model was further modified in the seminal work of Bollerslev (1986). by Hwang et al. (2002) for U. Sadorsky finds that the single-equation GARCH outperforms more sophisticated models in forecasting volatility of petroleum futures. oil market and by Oberndorfer (2009) for the oil market of Eurozone. (2004) for major industrialized countries. (2009) investigates the efficiency of a volatility model with regard to its ability to forecast for three crude oil markets (Brent. Other techniques such as moving average. The results state that the behavior of oil prices tends to change over short periods of time. In particular. More specifically. volatility iS examined over the full DATA sample and across the various sub-samples in order to analyze the robustness of results. It was shown that the CGARCH and FIGARCH models are better equipped to capture persistence than are the GARCH and IGARCH models. namely asymmetry and persistence of shocks. a number of papers dealing with volatility measuring and modelling has significantly increased and more sophisticated techniques are widely used today. which allows estimating two features of crude oil price volatility. Narayan and Narayan (2007) apply exponential generalized conditional heteroskedasticity (EGARCH) model. 5 .). and WTI).1. The general concept that has been proven to work better over high-frequent time series in financial markets is generalized autoregressive conditional heteroskedastic models (GARCH) and their modifications (such as TGARCH. Moreover. which gained popularity in research of financial time series. Morana (2001) uses the semiparametric approach that exploits the GARCH properties of the oil price volatility of Brent market. using several different univariate and multivariate models of ARCH type.S.

The thesis is organized as follows.3 Literature review 1.3. Chapter 4 gives an overview of another approach based on identification of fundamental factors. production quotas.4 Determining fundamental factors Contrary to the popularity of time series analysis applied to crude oil markets. the number of research papers investigating the impact of crude oil determinants on the price series is not as significant. 6 . (2008) investigates the factors that might have contributed to the quarterly oil price increase in more details. Kaufmann et al. a non-linear effect of OPEC capacity utilization and conditions in futures markets as explanatory variables and finds that this model performs relatively well in terms of forecasting. (2004) applies statistical models to estimate the causal relationship between crude oil prices and several factors. Krichene (2002) examines world markets for crude oil and natural gas and considers demand elasticities as factors that determine oil price changes. such as capacity utilization. Chapter 5 concludes. which may explain the dynamics of WTI crude oil prices.1. Kaufmann et al. by expanding a model for crude oil prices to include refinery utilization rates. In Chapter 2 methodology of time series analysis is introduced. Chapter 3 describes the data set and results of time series analysis of WTI and Brent crude oil prices and their volatility. and production levels.

I prefer to start with ARMA models as they are often considered as a classical technique applied to time series analysis.2 Methodology of time series analysis In this chapter the methodology used in this thesis is presented. discuss their main properties. 2.1. 7 . which allows to examine the dynamics of individual time series. Using such time series forecasting models allows us to forecast future events based on known past observations. Even though ARMA processes have sever disadvantages in modelling financial time series as it will be discussed below. We briefly introduce the main models used to model the financial time series.1 ARMA model ARMA models is a general class of models. squared GARCH processes may be seen as ARMA processes and understanding the fundamentals of ARMA might be useful for the further examination of GARCH processes. 2. some of their modifications and statistical tools applied to time series modelling. Furthermore.1 Modelling financial time series The essential point in financial time series analysis consists in the following: we need to present a model taking into account previous observations in order to extract significant characteristics of the data.

. The qth-order Moving Average process: M A(q) : Yt = µ + ￿t + θ1 ￿t−1 + θ2 ￿t−2 + .φp .. after choosing p and q. ￿t is a white noise process i. θq are real coefficients.q) model is usually done by plotting the partial autocorrelation functions for an estimate of p and likewise using the autocorrelation functions for an estimate of q.. + θq ￿t−q The pth-order Autoregressive process: AR(p) : Yt = φ0 + φ1 Yt−1 + φ2 Yt−2 + . + φp Yt−1p Mixed Autoregressive Moving Average processes: ARM A(p.. across time: E(￿t ) = 0. The usual way to estimate parameters in ARMA models. + φp Yt−1p − −￿t − θ1 ￿t−1 − θ2 ￿t−2 − .. Further information can be obtained by considering the same functions for the residuals of a model fitted with an initial selection of p and q.... {￿t } is a sequence whose iid elements have mean zero and variance σ 2 and are uncorrelated that Yt is modeled as a weighted average of past observations and a white noise error. E(￿t ￿s ) = 0 for t ￿= s.e.. E(￿2 ) = σ 2 . θ1 .2. This representation implies t Finding appropriate values of p and q in the ARMA(p. q) : Yt = φ0 + φ1 Yt−1 + φ2 Yt−2 + .1 Modelling financial time series A general ARMA model consists of two parts: an autoregressive (AR) part and a moving average (MA) part. .. is least squares regression such that the values of the parameters minimize the error term. − θq ￿t−q = p q ￿ ￿ = φ0 + φi Yt−i − θj ￿t−j i=1 j=1 where φ0 . The 1-step ahead forecast of Yh+1 can be easily obtained from the model as 8 . φ1 .

] = φ0 + φi Yh+1−i − θj ￿h+1−j i=1 j=1 ˆ and the associated forecast error is eh (1) = Yh+1 − Yt (1) .. One way to deal with this problem is to present the behavior of squared residuals ￿t as an AR(m) process: ￿2 = α0 + α1 ￿2 + α2 ￿2 + . The AR models imply the unconditional variance being constant. the multistep ahead forecast of an ARMA model can be computed recursively. as it was shown in different studies.. we are interested in forecasting not only the level of the series.] = V ar[￿0 ]. Changes in the variance are very important for understanding financial markets. Yh−1 . Moreover. and the estimation procedure itself is quite clear and well understood. For the l-step ahead forecast. ARMA processes give a good approximation of general stationary processes.. which should be estimated... However. ARMA models do not take into consideration conditional heteroskedasticity. the variance of 1-step ahead 2 forecast error is V ar[eh (1)] = σs .2 ARCH model In financial time series analysis. but also its variance. it is relatively simple to compute explicitly all the parameters. However. the next class of models seems to be more appropriate to analyze financial time series. Yh (l − i) = Yh+l−i if l − i ≤ 0.2.. as investors require higher expected returns that would compensate holding riskier assets. + αm ￿2 . since the variance is constant over time: Therefore. ARMA models are not suitable to evaluate the entire distribution of nonlinear processes.. .. The main advantage of ARMA models is their mathematical tractability. 2. ￿t−2 . V ar[Yt |￿t−1 .1. .] = φ0 + φi Yh (l − i) − θj ￿h (l − j) i=1 j=1 ˆ where ￿h (l − j) = 0 if l − i > 0 and ￿h (l − j) = ￿h+l−i otherwise. Yh−1 . t t−m t−1 t−2 9 . . Therefore. we need to take into account that conditional variance may demonstrate a different behavior and significantly change over time. we have p q ￿ ˆ ￿ ˆ Yt (l) = E[Yh+l |Yh .1 Modelling financial time series p q ￿ ￿ ˆ Yt (1) = E[Yh+1 |Yh .

2. which is asymptotically superior and more efficient. in order to improve the model. The Maximum Likelihood Method is used to estimate the parameters of the model: l= . β. The main idea behind the ARCH modelling is the following: the forecast based on the past information is presented as a conditional expectation depending upon the values of past observations. The following model with mean AR(p) process and conditional variance ARCH(q) process is more intuitive when dealing with financial data: p ￿ Yt = β0 + βi Yt−i + ￿t √ i=1 ￿ t = ν t ht 10 . Therefore. Thus. the variance of such a forecast depends on past information as well and may therefore be a random variable. we need to include this feature in the model. 1 T T ￿ lt log ht − 1 ￿2 /ht 2 t lt = t=1 −1 2 where xt includes lagged dependent and exogenous variables.1 Modelling financial time series The first model that provided a systematic framework for volatility modelling is the ARCH model of Engle (1982). ht ) √ Y t = ￿ t ht p ￿ 2 ht = α 0 + αi yt−i i=1 assuming that the mean of Yt is given as xt β and a linear combination of lagged endogenous and exogenous variables is included in the information set ψt−1 with β as a vector of unknown parameters. Engle shows that Ordinary Least Squares estimation gives not as good results as Maximum Likelihood. The likelihood function is maximized with respect to the unknown parameters α. The ARCH(p) model initially introduced by Engle has the following form: Yt |ψt−1 ∼ N (xt β. which we want to estimate.

Therefore. This feature is similar to the volatility clustering phenomena observed in financial time series. t • conditional distribution function of ￿t is a centered Gaussian distribution: F (￿t |ψt−1 ) ∼ N (0. it is well known that price of a financial asset responds differently to positive and negative shocks.1 Modelling financial time series ht = α 0 + i=1 q ￿ αi ￿2 t−i where νt ∼ N (0. this approach allows capturing the conditional heteroskedasticity of financial data and provides the explanation of the persistence in volatility. The coefficients of the model must also satisfy some regularity It can be seen from the model that large past squared shocks ￿2 imply a large cont ditional variance ht . 2.3 GARCH Model Bollerslev (1986) extended Engle’s framework by developing a technique that allows the conditional variance to be an ARMA process. under the ARCH framework. large shocks tend to be followed by other large shocks. Therefore. GARCH(p. Moreover. αi ≥ 0 for i > 0. α0 > 0.1.2. In practice. 1) are iid random variables or white noise. independent of the past ￿t . conditions to ensure that the unconditional variance of ￿t is finite. • conditional variance: E[￿2 |ψt−1 ] = ht . The ARCH model does not provide any new insight for understanding the source of variations in financial time series. ht ). the model assumes that positive and negative shocks have the same effects on volatility because it depends on the square of the previous shocks. However. It provides only a mechanical way to describe the behavior of the conditional variance and gives no indication about what causes such behavior to occur. ARCH models are likely to overpredict the volatility because they respond slowly to large isolated shocks to the return series.q) therefore has the fol- 11 . The main advantage of this model is that we take into account the fact that conditional variance is substantially affected by the squared residual term (that may be a result of significant changes on a market) in any of the previous m periods. The model defined above has the following properties: • conditional mean: E[￿t |ψt−1 ] = 0. In addition.

we have α ˆ ht+τ = 1−(α10+β1 ) + (α1 + β1 )τ [α1 ￿2 + β1 ht ]. we provide an estimate for the expected squared residuals: 2 E[￿2 ] = ht E[νt ] = ht .2. t Using the fact that E[￿2 ] = ht+1 . βj ≥ 0 for j > 0 and (αi + βi ) < 1. αi ≥ 0 for i > 0.q) ￿ that νt ∼ N (0. α0 > 0.1 Modelling financial time series lowing form: p ￿ Yt = c 0 + ci Yt−i + ￿t √ i=1 ￿ t = ν t ht p q ￿ ￿ ht = α 0 + αi ￿ 2 + βj ht−j t−i i=1 j=1 where νt are iid random variables with E[νt ] = 0. 1)). First. i=1 The latter constraint is necessary to ensure that the unconditional variance is finite. t Moreover. the forecast will converge to the unconditional variance: α ˆ ht+τ −→ 1−(α10+β1 ) . whereas the conditional variance ht evolves over time. we obtain t+1 ˆ t+2 = α0 + α1 ￿2 + β1 ht+1 = α0 + (α1 + β1 )ht+1 . The same reasoning may be applied for GARCH models of higher orders allowing us to compute multistep ahead forecasts. t Therefore. V ar[νt ] = 1 (it is often assumed max(p. 12 . 1) can be made by repeated substitutions. h t+1 Similarly. Volatility forecast from GARCH(1. if (α1 + β1 ) < 1 . Forecasting Let us now consider the particular simple case of GARCH model and see how forecasts may be constructed within this framework. considering forecasting horizon τ . t The conditional variance ht+1 and 1-step ahead forecast is known at time t: ˆ ht+1 = α0 + α1 ￿2 + β1 ht . ˆ ht+2 = α0 + (α1 + β1 )ht+1 = α0 + α0 (α1 + β1 ) + (α1 + β1 )2 ht+1 = = α0 + α0 (α1 + β1 ) + α0 (α1 + β1 )2 + (α1 + β1 )2 [α1 ￿2 + β1 ht ].

Jagannathan and Runkle (1993) models asymmetric consequences of positive and negative innovations in the GARCH process.1. in particular.4 EGARCH Model To overcome some weaknesses of the GARCH model in handling financial time series. The non-negativity condition is satisfied ￿ ￿ provided that βj ≥ 0. αi + γi ≥ 0. 2. 13 . to allow for asymmetric effects between positive and negative asset returns. it responds equally to positive and negative shocks. recent empirical studies of high frequency financial time series indicate that the tail behavior of GARCH models remains too short even with standardized Student-t innovations. we expect γi < 0 . GARCH models gained popularity because they often give a reasonable fit to financial data and can explain some of the stylized facts. In addition.1 Modelling financial time series In practice. Nevertheless. Conditional variance in this case is described as the following process: ￿t = √ ht ν t log(ht ) = α0 + j=1 q ￿ βj log ht−j + k=1 p ￿ [θk (￿t−k / ￿ ￿ ￿ ht−k ) + γk (|￿t−k / ht−k | − 2/π)] where logged conditional variance is used in order to relax the positiveness constraint of model coefficients.1.5 GJR-GARCH Model The GJR-GARCH model by Glosten. Additionally. For instance. Nelson (1991) proposes the exponential GARCH (EGARCH) model. this specific structure enables the model to respond asymmetrically to positive and negative lagged values of shocks ￿t . ￿t = √ ht ν t ht = α 0 + i=1 p ￿ αi ￿2 + t−i j=1 q ￿ βj ht−j + i=1 p ￿ γi ￿2 I{￿t−i ≥0} t−i If the leverage effect holds.2. the model encounters the same weaknesses as the ARCH model. 2.

Granger. Tests are also performed to see if certain 14 . Now we present necessary procedures that are used in this work. Model identification and model selection.2 General methodology and statistical tools 2. √ ￿ t = ht ν t p q ￿ ￿ hδ = α 0 + αi [|￿t−i | − γi ￿t−i ]δ + β j hδ t t−j i=1 j=1 2. Properties of models that are taken into account for choosing the best fitting model are presented below. 2.2.2 General methodology and statistical tools In previous section main time series models were introduced. In particular.6 APARCH Model One of the more general GARCH models is the APARCH model (Asymmetric Power ARCH) of Ding. In general. In particular. and Engle (1993). Parameter estimation using maximum likelihood estimation or non-linear leastsquares estimation. it nests at least seven ARCH-type models depending on parameters that may be chosen in a specific way. 1. One of the specific features of this model is a possibility to estimate a power coefficient δ that is assumed to be equal to 2 in all previous models. 3. the residuals should be independent and constant in mean and variance over time. 2.1 Choice and validation of time series model In the validation part. tests are performed to judge whether ARCH effects and autocorrelation have been removed or not. Model checking by testing whether the estimated model conforms to the specifications of a stationary univariate process.1. while modelling financial series. three main steps should be made.2. Therefore this model can be much more flexible than other models considered.

H1: data are not normally distributed. 2. pp. Ljung-Box test statistic for a number of tested lags k is Q(k) = N (N + 2) 1 i=1 k ￿ ρ2 ˆi T −i . Null hypothesis is rejected at α % significance level if JB > χ2 1−α. Jarque-Bera test statistic measures goodness-of-fit of departure from normality and is defined as follows JB = N 2 6 (S + 1 K 2 ). Box (1978).2 General methodology and statistical tools assumptions about the model are fulfilled. ”Efficient tests for normality. H1: data are correlated (not random). Carlos M. where χ2 1−α.1. ”On a Measure of a Lack of Fit in Time Series Models”. 15 .e. G.2 . are the normalized residuals distributed in the way that was assumed in the model.2 is a α-quantile of the chi-square distribution with 2 degrees of freedom. Ljung. H0: data are not correlated. 2. Biometrika 65. (1980). 4 where N is the sample size.2. Economics Letters 6 (3): 255259. Bera..2 Ljung-Box test Ljung-Box test2 is performed to test whether series have significant autocorrelation or not. i. 297303. E. P. 2 G.1 Jarque-Bera test Jarque-Bera test1 is used to test whether a given distribution is normal or not. Jarque.2. M. H0: data are normally distributed. homoscedasticity and serial independence of regression residuals”. S is the sample skewness and K is the sample kurtosis at lag k.1.2. Anil K.

1 Choice of time series model based on forecasting performance Forecast performance measures based on loss function A good performance measure can be hard to find since the volatility is not directly observable.k .3.Bayes information criterion BIC is a criterion for model selection among a class of parametric models: BIC = −2 log(L) + k log(n).3 2.k is a α-quantile of the chi-square distribution with k degrees of freedom.2. The preferred model is the one with the lowest AIC value. The term 2k is a penalty as an increasing function of the number of estimated parameters. Null hypothesis ˆi 2 is rejected at α % significance level if Q(k) > χ2 1−α.2 General methodology and statistical tools where N is the sample size. • AIC . 2. where L is the maximized value of the likelihood function for the estimated model.2. k is the number of parameters in the statistical model. where L is the maximized value of the likelihood function for the estimated model. • BIC . Given any two estimated models.2. several competing models may be ranked according to their values of a chosen information criterion. the model with the lower value of BIC is the one to be preferred. 2. n is the sample size.2. Therefore it makes sense not to rely on one specific measure but rather 16 . where χ1−α.2 Choice of time series model based on information criteria Another possible approach to analyze different models is use of information criteria.Akaike information criterion AIC is a measure of the goodness-of-fit of an estimated statistical model: AIC = −2 log(L) + 2k. Given a data set. k is the number of parameters in the statistical model. ρ2 is the sample autocorrelation at lag k.

In this approach squared residuals ￿2 are used as a measure of actual volatility. This t choice may be justified using the following equation: ￿ √ √ ˆ E[￿2 ] = E[ ht νt ] = 1E[ ht ] = ht t time t. ht is the actual volatility on day t. The criteria MSE (1).2 Diebold-Mariano test Indicators presented above are useful to compare a number of models.2 General methodology and statistical tools use several measures.2. Mean Absolute Deviation M AD = |ˆt − h2 | σ2 t ￿ ￿2 3. Nevertheless. since νt ∼ N (0. In this work four different forecasting performance measures are considered for evaluating the performance of volatility forecasts from different GARCH models: 1. 17 . QLIKE (3) corresponds to the loss function implied by a Gaussian likelihood.3. These forecast performance indicators are used in order to estimate forecast accuracy in terms of loss functions. smaller forecasting error statistics indicate the superior forecasting ability of a corresponding model. given a set of competing models. Mean Squared Forecast Error R2LOG = log(ˆt h−2 ) σ2 t where n is the number of forecast data points. Engle. 1) and ht is a conditional variance of ￿2 given information available at t 2. Mean Squared Error M SE = 1 n n ￿ i=1 (ˆt − h2 )2 σ2 t 1 n n ￿ i=1 2. Indeed. Quasi Likelihood QLIKE = 1 n n ￿￿ i=1 log(h2 ) + σt h−2 ˆ2 t t 1 n n ￿￿ i=1 4. the main shortcoming of this method is that these indicators contain no information whether the difference between two models is statistically significant.2. MAD (2) and R2LOG (4) were suggested by Bollerslev. σt is the volatility forecast for date ˆ2 t. and Nelson (1994).

It was suggested by Diebold and Mariano (1995). H1 : E[dt ] ￿= 0. n and n is a number of forecast data points obtained from a model.t where t = 1.e.. i. Given two different models. and γk .t ) − g(e2.t ). . The Diebold-Mariano test statistic is ￿ ￿−1/2 DM = V ˆ (d) d. 18 . H0 : E[dt ] = 0. two models provide different forecast accuracy. two models provide equal forecast accuracy. i.asymptotic variance of the mean of the difference between the fore(d) ￿ casting errors as V (d) ≈ n−1 [γ0 + 2 γk ].2 General methodology and statistical tools Second approach involves using statistical test that examines forecast accuracy for two sets of forecast. Then g is chosen as a function of forecast errors and the difference of errors of two corresponding models is computed: dt = g(e1.2. forecast errors are computed as a difference between actual and forecasted values: e1.k-th autocovariance of dt . Negative value of the DM statistic suggests that Model 1 statistically dominates Model 2...t and e2.e. where V ˆ . Under the null hypothesis DM test statistic has an asymptotic standard normal distribution.

3. we analyze dynamics of return series rather than price series themselves. 1995 to March 11. In general. 2010 and contains 3910 and 3909 observations for WTI and Brent crude oil markets respectively1 . t−1 Here Pt denotes the price of crude oil at time t. 1 The data set was kindly provided by Total. 19 . Then estimation of four competing GARCH-related models and evaluation of their forecasting accuracy is performed. returns are calculated in the following way: Rt = Pt −Pt−1 Pt−1 .3 Empirical results In this section we briefly discuss properties of data set of WTI and Brent crude oil. In order to assure that there is no trend component and data are stationary to some extend. The datasets consist of daily closing prices over the period from January 2. The usual way to proceed is to compute returns on a continuous compounding basis: rt = ln(1 + Rt ) = ln( PPt ).1 Properties of the data set We analyze West Texas Intermediate (WTI) and Brent crude oil spot prices (in US dollars per barrel).

thus density function is characterized by fat tails comparing to the density of the Gaussian distribution N (0. while returns of Brent 20 .January 2. 1995 to March 11. periods of high volatility are followed by periods of relatively low volatility.1 Properties of the data set Fig. Figure 3. The behavior of prices and returns is clearly unsteady and dynamics of returns gives an evidence of volatility clustering. 2010. 3. 1). It also may be seen from graphs of the density functions (Figure 3.3.e. i.1.e. namely data are right skewed (i.1: Dynamics of daily prices and returns of West Texas Intermediate and Brent crude oil markets (US Dollar/Barrel) . • Kurtosis is greater than 3 in all cases. • Coefficient of skewness is positive for prices of WTI and Brent markets and for returns of WTI market indicating that there is an asymmetry of the probability distribution. Basic descriptive statistics is presented in the Table 3. right tail is longer and the mass of distribution is concentrated on the left of the figure). This behavior is known to frequently occur in financial markets.1 illustrates dynamics of two markets considered.2).

0005848455 0.1: Descriptive Statistics of WTI and Brent prices and returns series.02205891 -0.80 40.1643000 -0.1 Properties of the data set WTI Prices Number of observations Mean Variance Standard deviation Skewness Kurtosis Minimum 1st Quantile Median Mean 3rd Quantile Maximum Jarque-Bera statistic 3911 40.324662 4.0003910 0.0139300 0.94359 688.0130500 0.942048e -0.069 (0.0007449 0.48 28.78 1490.1920000 2539.73698 703. 21 .02418358 0.23187 1.51578 1.0003910 0.970388 -0.1534000 -0.2138000 5827.453592 10.0000) Table 3.231 (0.1112 26.61 1419.0000) Returns 3911 0.55 145.07286083 6.0119300 0.18 39.1301484 8.74 58.27 145.5 20.0000) Brent Returns 3910 0.3.359510 9.308778 4.0124200 0.0004865956 0.0000) Prices 3910 39.7 19.94 59.0004051 0.061 (0.82 29.0868 26.2 (0.0004051 0.0007206 0.

3) of oil prices and oil returns indicate that of the series. • Furthermore. both large positive and large negative shocks are responsible for the non-normality Figure 3.WTI and Brent crude oil markets 22 . QQ plots (see Fig.3: Q-Q plots of crude oil prices and returns .3.1 Properties of the data set market are left skewed since the value of the coefficient is negative (i. 3.2: Histograms and density plots of crude oil prices and returns . • In particular. left tail is longer and the mass of distribution is concentrated on the right of the figure). statistics of JarqueBera test suggest that neither oil price series nor oil returns series of both markets are normally distributed.e.WTI and Brent crude oil markets. Figure 3.

ACF helps to identify an order of MA process q. Figure 3. in particular. 3.3.4: Autocorrelation and Partial Autocorrelation functions of WTI returns . 3.low values of autocorrelation indicates the absence of serial dependencies across series Fig.high values of autocorrelation indicates the presence of serial dependencies across series Figure 3.2 GARCH modelling In this section the whole data set is used to fit a respective model of conditional heteroskedastic variance for both crude oil markets.5: Autocorrelation and Partial Autocorrelation functions of Brent returns .2 GARCH modelling 3. The form of the mean equation is determined by following the Box-Jenkins approach.5 picture graphs of autocorrelation (ACF) and partial autocorrelation (PACF) functions that allow to determine whether there are serial dependencies in series across time. 23 .4 and Fig.

1): ￿t = √ ht ν t log(ht ) = ω + α1 ￿t−1 + β1 log(ht−1 ) + γ1 (|￿t−1 | − • APARCH(1. which are also often observable while dealing with financial time series.3. • GARCH(1. such models as GJR-GARCH. in case of Brent returns. EGARCH and APARCH models take into account asymmetric effects. To simplify the interpretation of the model. Use of these four models allow us to determine specific features of two crude oil markets and further compare them. In other words. ACF and PACF graphs reveal no sign of dependencies among observations that implies that Brent returns most likely follow a process similar to a random walk: Yt = µ + ￿ t Crude oil markets are characterized by persistence of shock.2 GARCH modelling while PACF is used to settle an order p of the AR part for the corresponding ARMA model. therefore four different generalized conditional heteroskedasticity models are used in order to capture this feature.1): √ ￿ t = ht ν t ht = ω + α1 ￿2 + β1 ht−1 + γ￿2 I{￿t−1 ≥0} t−1 t−1 • EGARCH(1.1) is chosen to represent this process.1): ￿t = √ ht ν t ￿ 2/π) hδ = ω + α1 [|￿t−1 | − γ1 ￿t−1 ]δ + β1 hδ + γ￿2 t t−1 t−1 24 . ARMA(1. Moreover.1): ￿t = √ ht ν t ht = ω + α1 ￿2 + β1 ht−1 t−1 • GJR-GARCH(1. both past observations and random component will have an impact on today data: Yt = µ + a1 Yt−1 + b1 ￿t−1 + ￿t However. Presence of autocorrelations in the WTI series suggests that WTI returns show some autocorrelations and an adequate model for mean equation is needed.

we expect α ≈ 0. Estimates of this parameter are statistically significant for all four models and positive for GARCH. 1). The lowest value (α = 0.94).3. which that measures persistence of volatility shocks. Innovations are assumed to be of standard normal distribution: νt ∼ N (0.04979.3 Results of estimation We estimate the selected models using the maximum likelihood estimation technique and assuming normally distributed errors. 1 Estimation procedure based on the maximum likelihood method was performed in R 25 . 3. α from the GARCH(1. indicating that old shocks to crude oil price volatility tend to persist. value of β is close to 1 (around 0. This implies that shocks have permanent effects on crude oil price volatility. a1 and b1 are GARCH model parameters. Tables 3. Values in parentheses are standard errors of corresponding parameter estimates. however the sign is negative in the case of EGARCH model that can be explained by the construction of EGARCH model that does not impose any constrains on signs of parameters.05). The numbers in brackets are p-values of test statistics. Log(L) is the value of maximized Gaussian log likelihood function.3 Results of estimation where ω is unconditional mean.2 and 3. which is the closest value to the theoretical benchmark used in GARCH modelling (in general.03039) corresponds to the GJR-GARCH model since in case of this model we take into consideration so-called leverage effect (not all shocks have the same influence on volatility). GJR-GARCH and APARCH. δ is power term. For all models considered. rather than die out rapidly.1 WTI crude oil market • The coefficient α captures influence of new shocks on volatility. • The parameter β.3 contain results of estimation for WTI and Brent crude oil markets respectively 1 . Also additional indicators are computed in order to detect the best time series model for a given data set.3. 3. γ1 is asymmetry term. is positive and statistically significant at 1% level.1) fitted model is equal to 0.

05 22.00731) (0.17280) (0.17254) (0.0000] (0.7639] [0.1159] [0.8284] [0.04979 0.59 9400984 -4.08332] [0.0000) (0.17967] [0.9446] [0.53 22.14613) (0.6590] [0.00357) (0.00603) 0.01537] [0.491 10.3176] [0.013e-07] [0.15003) (0.0000) (0.09115) GJR-GARCH EGARCH APARCH Residuals.7520 [0.8442] [0.67221 -0.02284 0.7506 -4.18424 9319.815 67.05412] [0.7260] [0.47 19.3.695 15.67573 -0.283 6.03 6.15214) (0.12046 -0.150 5667.001) (0.00242) (0.64 71.98341 0.00004 0.00028) (0.586 9.00057 0.03700] [0.697 9.93466 9314.60 11.02848 9319.93961 0.95 26. WTI returns.8505] [0.0000] [0.446 6.70479 -0.04063) (0.06 5639.7394 [0.00030) (0.43 9315841 -4.554e-10] [5.04063 0.10799 9294.7632 -4.73293 0.69 10.97 21.0073) (0.861 10.7608 -4.0000] [0.0000] [0.70962 -0.00358) (0.00036) (0. 26 .7537] [0.0000] [1.994 9.69405 0.0000] (0.70188 -0.182e-09] [1.00074 0.7805] [0.10 29.2: Estimation results of four conditional heteroskedasticity models.00061) 0.9638] [0.72541 0.10099] [0.00059 0. Test statistics Information criteria Table 3.00001 0.55 9540951 -4.00033 0.0000] (0.0507) (0.00001) (0.17 69.01358) 0.231 5668.03986) (0.9654] [0.0000] (0.03039 0.1513 2.02686) (0.795 18.9551] [0.27 25.7628 -4.637 5688.7500 [0.00034) (0.3 Results of estimation WTI GARCH Coefficients µ a1 b1 ω α1 β1 γ δ Log(L) Q[10] Q[15] Q[20] JBstat Q2[10] Q2[15] Q2[20] JBstat2 AIC BIC 0.7496 [0.0037) (0.1908] [0.00001 0.93843 0.23 9410604 -4.1482) (0.452 7.598 10.

GJR and APARCH and is slightly greater in the case of the EGARCH model (0. similarly to the WTI market meaning that shocks are highly persistent on this market. p-values of the test applied to the EGARCH model.988). • The power coefficient δ in APARCH model is 1 % significant and equal to 2. while the results of Ljung-Box test for different lags implies specifically. • The asymmetry coefficient γ is significant at 1 % level only in EGARCH model. are very low (close to 0) suggesting that this model can hardly be used to adequately describe WTI data set.12.94 for GARCH. • Ljung-Box test on squared residuals indicates that substantially squared residuals test. the positive sign suggests that positive shocks reduce volatility more are not independent.2 Brent crude oil market • The value of parameter β ∼ 0.3. GARCH model demonstrates the highest p-values of the 3. APARCH model also shows fairly acceptable p-values. while being not significant in GJR-GARCH and APARCH. This suggests that asymmetry effect of shocks on Brent market is not considerable in contrast to the WTI crude oil market. than negative shocks. for example if we consider lag h = 20. • Both AIC and BIC indicate that GJR-GARCH provides the best fit to the data.3. 27 . in 30 % cases sqaured residuals will be not correlated. This indicates that shocks have asymmetric effects on the volatility of crude oil prices.3 Results of estimation • The asymmetry coefficient γ is positive and significant at 1 % level. distributed residuals. on the contrary. • Jarque-Bera test suggests that none of the models presented above has normally that residuals are independent that is necessary in order to conclude that a model is valid. It is remarkable that estimates of α and β of Brent crude oil prices are slightly greater than these estimate computed for the WTI market. It may indicate that Brent oil prices sre more liable to shocks both new and persistent comparing to the WTI oil prices. suggesting that heteroskedasticity was partially removed.

006942) (0.30 19.00781) 0.10641 9616.698 12938239 -4.9208 -4.061 6.125 10.00002 0.3: Estimation results of four conditional heteroskedasticity models.9128 [0.5444] [0.061 7.064 8.155 7.00725) (0.9481] [0.0000] (0.00066 0.095 12933561 -4.688617 9623.9263] [0.00001 0.05051 0.94249 9622.943588 0. 28 .079957 1.424 10.6725] [0.3 Results of estimation Brent GARCH Coefficients µ ω α1 β1 γ δ Log(L) Q[10] Q[15] Q[20] JBstat Q2[10] Q2[15] Q2[20] JBstat AIC BIC 0.01297) 0.637 4.98699 0.00031) (0.751 5.00632) (0.00001) (0.9401] [0.79 4.00674) (0.00032) (0.13 12939426 -4.9331] [0.04117 0.9533] [0.00308) (0.00065 0.168 13.031 6.952 10.0000] [0.2982] [0.061 7.422 7.00065 -0.02378) (0.9097 [0.9565] [0.024619) GJR-GARCH EGARCH APARCH Residuals.7095] [0.9159] [0.0000] [0.926 14.9111 [0.8869] [0.01022 9622.002764) (0.00072 0.09682 -0.991 15. Test statistics Information criteria Table 3.928 2539.4962] [0.6360] [0.0003) (0.9205 -4.0000] (0.9178 -4.664 12.061 11.944199 0.81 17.0000) (0.3015] [0.0000] [0.191 11.0000) (0.00189) 0.00029) (0.752 16.9460] [0.0000] (0.7637] [0.5135] [0.9541] [0.3.0000] (0.0000] [0.01623 0.00081) (0.7107] [0.390 16.00001 0.186 4.9590] [0.9125 [0. Brent returns.575 2539.219 12880908 -4.04801 0.471 2539.713 2539.053276) (0.9208 -4.7567] [0.9448] [0.6030] [0.

p-values of this test are the highest in case of GARCH and GJR-GARCH model 3.3. • BIC statistic chooses GJR-GARCH as the best fitting model. we analyze the forecast performance of four conditional heteroskedasticity models: GARCH. These forecast performance measures are presented in the Table 3. similarly to the WTI market. while the remaining part is used to test the forecasts. The out-of-sample measures are computed with one step ahead prediction (not reestimating the coefficients) and then for the next day. The whole data set is divided in two parts.4. that suggests that the usual representation used in GARCH model may not be • According to the Jarque-Bera and Ljung-Box test statistics. GJR-GARCH. and lowest. which is a necessary condition to conclude that the models are valid.4 Forecasting Considering out-of-sample forecasts.4. EGARCH and APARCH. We consider different time horizons to perform volatility forecasts and then compare those values with the actual realized volatility from time series by means of different statistical indicators and tests. we use different forecast performance indicators in order to estimate forecast accuracy in terms of loss functions as it was indicated in previous sections. when new information is available. the first one is used to estimate the parameters of the models. residuals are not normally distributed for each model. but not correlated across series. in case of EGARCH model.4 Forecasting • The power coefficient δ in APARCH model is 1 % significant and equal to 1.1 Forecast performance measures Since there is not a unique criterion for selecting a model giving the best forecast. • Ljung-Box test on squared residuals indicates that squared residuals are independent. whereas AIC gives to equal values for GJR-GARCH and APARCH models. 3. According to the MSE criterion APARCH model suits better shorter 29 . appropriate. the prediction is made again. • MAD and QL suggest that the most accurate forecast model for WTI oil prices is APARCH.69.

00056152 0.9606 8.8826 -6.6199e-07 4.00049793 -7.00041265 0.00046157 0.100-day horizon .0985 -6.2817e-07 3.2558 4.7922 6.5813 -7.0404 -6.427 9. Forecast performance measures.00036643 0.100-day horizon .4717e-07 0.0761 -6.4 Forecasting GARCH WTI MSE .7434 6.100-day horizon .00040608 0.00051869 0.05 6.3.1928e-07 2.00040149 0.3026 4.0005055 0.50-day horizon .1306e-07 2.9706 Table 3.00043692 0.1831e-07 2.50-day horizon .100-day horizon .4945 9.1127e-07 2.200-day horizon GJR-GARCH EGARCH APARCH 2.3141e-07 3.7308 -7.50-day horizon .1246 -6.4925e-07 3.7189 7.200-day horizon R2LOG .100-day horizon .4266e-07 3.9534 7.6335 12.1004 -6.9537 12.50-day horizon .639 8.200-day horizon BRENT MSE .1533e-07 2.4: Volatility forecasts of WTI and Brent crude oil returns.5561e-07 2.100-day horizon .0198e-07 4.931e-07 2.0004519 0.0003693 0.4543 9.200-day horizon MAD .50-day horizon .9394 -6.6592e-07 2.50-day horizon .9482 -6.100-day horizon .7241 -7.6552e-07 4.6339 -7.00045093 0.200-day horizon Q2LIKE .50-day horizon .7233e-07 0.439 7.093 8.00040797 0.5042e-07 2.127 8.200-day horizon Q2LIKE .00038480 0.122 8.8758 -6.200-day horizon R2LOG .3491 2.8328e-07 2.1072 -6.384 4.8193 -6.7012 -7.00046487 -7.4142 11.50-day horizon .1206 -6.2418e-07 3.00043030 0.00038342 0.1000e-07 2.8619 -6.00038819 0.00037312 0.00047877 0.1154 -6.2943e-07 2.200-day horizon MAD .6394 12.9327 -6.00042851 0.3866 9.3328 4.7318e-07 4.6943e-07 2.00043628 0.9115 -6. 30 .8567 6.00048796 0.626 -7.100-day horizon .

EGARCH model is significantly outperformed by GARCH.4. In particular.4513 [0. GARCH GARCH GJR-GARCH EGARCH APARCH GJR-GARCH 2. As it was mentioned in the previous chapter.5 and 3. however it is less accurate than forecast performance of APARCH and GJR. 3. These indicators are useful to compare a number of models between each other.4 Forecasting forecasts rather than longer prediction.0000] 1. APARCH statistically 31 . GJR-GARCH model is claimed to be giving the most accurate forecast for 200-day time horizon.0000] -11. • Brent market may be characterized as more homogeneous in the sense that almost all criteria across different horizons suggest GJR-GARCH as the most accurate model.7623 [0.8368 [0.0000] APARCH 4. Diebold Mariano test statistics. WTI GARCH produces more accurate forecast comparing to EGARCH.5: Volatility forecasts of WTI crude oil returns. the main shortcoming of this method is that there is no information whether the difference between two models is statistically significant. Nevertheless.2135 [0.2 Diebold-Mariano test Results of DM test for WTI and Brent crude oil are presented in Tables 3.0057] EGARCH -8. R2LOG is however less consistent and best model varies if we change the time horizon of forecasting.0000] - Table 3. GJR-GARCH and APARCH.1045] 12.3.3856 [0.6 (forecasting horizon was taken as n=100). Only the value of the R2LOG indicator (n=200) speaks in favour of EGARCH.6233 [0. negative value of the DM statistic suggests that Model 1 (left side of the table) statistically dominates Model 2 (upper side of the table).

in particular. GJR-GARCH and APARCH.5 Summary dominates GARCH and EGARCH according to the significant values of corresponding DM statistics. EGARCH model is significantly outperformed by GARCH. WTI market can be also described using GARCH models. • However.004296] 2.03234] EGARCH -3. GARCH modelling applied to Brent crude oil returns is appropriate since the heteroskedasticity of returns time series was successfully removed that autocorrelations in squared residuals were not completerly eliminated. GARCH GARCH GJR-GARCH EGARCH APARCH GJR-GARCH 2. Brent GJR-GARCH statistically dominates all the other models.3. • First of all.8556 [ 0. Diebold Mariano test statistics.00026] -5. However. However. there is an evidence GJR-GARCH gives a good fit. As of the WTI crude oil market. through GARCH modelling.0000] APARCH -0. As in the case of WTI crude oil prices.7898 [0.6: Volatility forecasts of Brent crude oil returns.7153 [ 0.1402 [0. they generate the most accurate predictions. in terms of forecast accuracy APARCH 32 . Based on the estimation the following remarks can be made.5 Summary Four GARCH-related models were used to model returns of WTI and Brent crude oil markets. is superior than other models. we conclude that due to the possible leverage effect that is taken into account in GJR-GARCH and APARCH models. comparing APARCH and GJR does not allow to reject the null hypothesis. Thus.00334] - Table 3. 3.6495 [ 0. Therefore. GJR-GARCH provides the best volatility forecast for the Brent oil prices.9342 [ 0.4744] -2.

and these effects are stronger for volatility of Brent crude oil prices.3. • In general.5 Summary • GJR-GARCH model gives the best fit for the Brent returns series and outperforms other competing model in forecast accuracy. At the same 33 . our findings suggest that shocks have permanent effects on volatility time asymmetric effects prevail in WTI series rather than in Brent series.

trading tactics etc. In general. Therefore. Weekly frequency is chosen since there is no daily statistics available for most of the explanatory factors. it makes sense to include factors related to fundamental supply and demand drivers. fluctuations in oil prices can be caused by supply and demand imbalances arising from a specific way these markets function as well as a number of peculiar events like wars. crude oil prices are also severely affected by the number of factors that can not be observable and quantified directly. We assume that there exist some fundamental factors that contribute to the price dynamics. data set contains 1012 observations from November 11. 1990 to March 26. economic crises. such as consumers expectations. Therefore from the point of view of the general supply-demand economic theory. which may explain oil price dynamics.4 Determining fundamental factors In this section we examine a set of factors. political aspect etc. 34 . we include in the analysis some additional factors that describe general economic situation of the US crude oil market. The length of the data sample is also subject to data availability. However. 2010. 4. changes in political regimes.1 Data set and choice of factors In this section weekly WTI crude oil prices are taken. Fundamental factors are to be revealed by means of Principal Component Analysis and evaluated using regression models. Weekly WTI crude oil prices and corresponding weekly returns are considered as explained variables.

If petroleum stocks are filled (released) then demand increases (decreases) and crude oil prices might rise (fall).1 Data set and choice of factors The following factors are considered as fundamental factors affecting WTI crude oil prices1 : • U. positive coefficients can also be expected. It can be interpreted as an indicator of the independence from price shocks and should have a negative impact on oil prices.S. crude oil supply directly depends on the number of rigs in operation. This variable was constructed by Kaufmann et al. A lack of spare refining capacity is seen as one cause for the on-going rise in the price of crude oil. An increased need for crude oil shifts the demand curve in a price-quantity diagram to the right and thereby increases the oil price given not completely elastic supply curve. According to Kaufmann et al. therefore. (2004) and is the ratio of crude oil stocks in million barrel and crude oil demand in million barrel per day. Refinery Operable Capacity (Thousand Barrels per Day). 1 Data source: U. Crude oil stocks are created to prevent unforeseen circumstances cutting down oil supply. Presumably. • U.gov/ 35 . However. • U.S. Energy Information Administration.4. A refining capacity is defined as the maximum amount of crude oil that can be processed in a calendar year divided by the number of days in the corresponding year and characterizes how well the downstream sector is developed. • Number of U. we assume a negative trade-off between the number of rigs and crude oil spot prices. Market Demand (Thousand Barrels per Day).eia.S. (2004) negative impact of stocks on the price is expected since an increase in stocks reduces real oil price by diminishing reliance on current production and thereby reducing the risk premium associated with a supply disruption. Crude Oil Stocks (Thousand Barrels). • Days of Forward Consumption of Crude Oil Stock (Number of Days). Rotary Rigs in Operation (Count) A rotary rig is a machine used for drilling wells. http://www.doe.S.S.

1 Data set and choice of factors • WTI Crude Oil Future 4 Months Contract (Dollars per Barrel) Agents’ expectations in the long-run may also influence oil prices. which. • S&P 500 Index. Decreasing interest rates will make lendings more accessible and will stimulate crude oil demand. Thus the we expect negative effect of interest rates. • Spread between Crude Oil Future Contract 4 and Crude Oil Future Contract 1 traded on the New York Mercantile Exchange (Dollars per Barrel). These two factors can served as indicators of the level of economical development as well. in turn.or in backwardation . These futures prices indicate a price for a contract specifying the earliest delivery date as 4 months ahead. • U. 36 .S. thus assumed sign is positive. in turn. Interest Rate (Percent per Year).S. We expect the corresponding coefficient to be positive as contango is expected to have a positive effect on prices because the higher price for future deliveries provides an incentive to build and hold stocks. Greater price for such a contract would suggest that consumers expect prices to grow as well in the future. which bolsters demand.the price of crude oil for four month contracts is greater than the price for near month contracts . will contribute to the oil prices increase. • U. Economical growth bolsters up demand for crude oil and therefore upholds crude oil prices. This index characterizing state of financial markets is included here to represent general financial situation and its possible effect on oil prices. the oil prices. According to a number of previous studies there is a strong relation between crude oil prices and stock markets.the price of crude oil for four month contracts is less than the price for the near month contract) might also affect the stock behaviors and. Gross Domestic Product and Growth Rate (percent change with respect to the last period). We assume that increase of S&P 500 index will have a positive effect on oil prices. The conditions on the futures markets (whether the market is contango .4.

Correlation between price and demand is average (0. positive sign indicates a certain positive dependence between these two variables: according to the supply-demand theory. indicating that level of economical development upholds an increase in crude oil prices.2 Correlations and linear regression Explanatory variables used in the current analysis of crude oil prices and corresponding hypotheses are summarized in the Table 4.1.554). Fairly high correlations are observed between oil prices and the index of industrial index S&P index (0. Results are presented in the Table 4. Correlation between prices and values of refinery capacities is surprisingly high and positive (0. The Table 4.4. increasing demand will urge prices on increasing. while price series are characterized by extremely high correlations with future contracts.8). however. Correlations greater than 0.2. which is perfectly explainable (correlations ∼ 1).2 Correlations and linear regression First step of the analysis includes examination of correlations. we are interested whether there are simple correlations between prices and some of the factors presented above.2 illustrates that price returns are weakly correlated with all the factors considered. even though it was assumed that growth of refinery capacities would stimulate production and supply and therefore lead to decrease in oil prices. 4. 37 . Basically.75 are highlighted.543).

38 .1: List of variables used in the analysis of fundamental factors affecting WTI crude oil prices.4.2 Correlations and linear regression Analyzed variables V1 V2 PRICE RET Weekly WTI crude oil spot price WTI crude oil spot returns Explanatory variables Demand factors V3 V4 DEM DAYS Weekly US market demand Weekly days of forward consumption of crude oil stock (+) (−) Supply factors V5 V6 V7 STOCKS CAP RIGS Weekly US crude oil stocks Weekly US refinery operable capacity Number of operating rigs (+/−) (−) (−) Trading factors V8 V9 F4 F41 4 month NYMEX crude oil future contract Spread between crude oil future contract 4 and contract 1 (+) (+) General economical development factors V10 V11 V12 V13 INT SP GR GDP Weekly Weekly Weekly Weekly US interest rate S&P 500 Index US real growth rate US real GDP (−) (+) (+) (+) Table 4.

18988 5.3E-06 4.69 -0.184 -0.554 -0.24 -0. Therefore.04 -0.3E-05 0.04 -0.23 -0.74 -0.00939 7.31033 0*** 0*** 0.08 0.0042 3E-05 t-statistics 1.37 -0.08757 3.94525 0.3971 -1.3 and 4.09 0. even though R2 is very high.04 0.16 140.4.35 0.09251 0.34 0.4 0.122 -0.212 -0.22 1 Table 4.543 -0.9E-05 -0.026 -0.9E-05 Standard error 1. these two models can be hardly used to explain dynamics of crude oil prices and returns.12255 0.01 0.3304 -0.82 -0.44 -0. At this point a linear regression model is estimated in order to see whether the chosen set of factors can explain price variations across considered time period. WTI crude oil spot prices.33 0.69138 0.35 -0.00745 0.8E-05 0.23 0.04 0.19 0.68393 -1.15 -0.35 -0.34476 0.54 0.32 0.81 -0.13543 -0. WTI crude oil spot price Estimator Const DEM DAYS STOCK CAP RIGS F4 F41 INT SP GROWTH GDP 2.55 -0.00367 -8.00064 1.997 -0.78 1 0.86 -0.769 DEM DAYS STOCK CAP RIGS F4 F41 INT SP GR GDP 1 -0.8923 0. Results of estimation are shown in Tables 4.4E-05 -0.74117 0. When modelling crude oil prices.75 0. only two factors appear to be significant (F4 and F41).32597 1012 0.04 0.25 -0.5E-05 1.72 1 -0.9E-05 -3.5E-05 0.8E-06 1.07 -0.16473 0.05 PRICE 1 0.55 0.26067 0.46 1 -0.39035 1.54546 -1. 39 . As it can be seen from tables above.31 -0.15 0.01 0.00057 -2.839 1 -0.31 0.7E-05 3.23 0.809 -0.31 1 -0.798 -0.04316 0.04 0.01504 1246.98274 p-value 0.2: Cross correlation analysis.28 1 -0.12544 0.082 0.4. which is a direct consequence of their high correlations with explained variable.69 1 -0. we can not come to any conclusion based on this model.13 -0.171 -0 -0.55 0.51 0.95 1 -0.54 -0.3: Estimation of linear regression model with the initial set of factors.35 -0.0008 0.1 0.05 0.41 0.84 1 0.07 0.06298 3.09 0.41 0.07 0.72 0.999873 Number of observations R2 Table 4.11 -0.00888 2.2 Correlations and linear regression RET PRICE DEM DAYS STOCK CAP RIGS F2 F41 INT SP GR GDP RET 1 0.53 0.74 -0.

while refinery capacity and number of operating rigs have a negative impact. As a matter of fact.06856 0.31188 -0.5929 0.0007 0. In the next section an attempt to improve these results is made based on the methods of principal component analysis.5902 0.3 Principal component analysis WTI crude oil returns Estimator Const DEM DAYS STOCK CAP RIGS F4 F41 INT SP GROWTH GDP 8.13882 0.01156 0. As of the returns.71189 0.00044 t-statistics 0.00051 0.46595 1012 0.3.8382 1. a low value of R2 (7 %) suggests that this model does not give a particularly good fit to the data. prices of future contracts have a positive influence of crude oil price returns.87379 0.1 Principal component analysis Theoretical background PCA is a multivariate statistical technique which calculates the principal directions of variability in data.415 0.4E-05 0.0012 0.00086 0.9E-05 0.38244 0.05711** 0.01591*** 0.93108 4.55339 0. However.3694 -0.1E-10*** 0.45856 -0.94536 0.06208 0.33037 4. 4.97384 6.0003 -0. 40 . this conclusion is in line with our initial assumptions.070652706 Number of observations R2 Table 4.4. An effect of stocks seems to be unimportant since the corresponding coefficient is close to zero.3 4.6854 -2. Finally.11009 0.69486 -0.00032 Standard error 17. WTI crude oil returns. These principal components represent the most important directions of variability in a dataset.01187 0.40213 0.4: Estimation of linear regression model with the initial set of factors. and transforms the original set of correlated variables into a new set of uncorrelated variables. The new uncorrelated variables are linear combinations of the original variables.7804 9.0012 -0.05424 0.64665 0.72937 p-value 0.06619 -0.0823 7.4E-05 -0.09222** 0.00108 0. three supply-related factors are statistically significant.90467 -1.

but does not affect the spatial relationships of the data nor the variances along our variables. The elements of an eigenvector are the weights aij .. weights are calculated with the constraint that their sum of squares is 1: a2 + a2 + .4. perpendicular to) the first principal component and that it accounts for the next highest variance.. At this point. 11 12 1p The second principal component is calculated in the same way. This will insure that the cloud of data is centered on the origin of our principal components.. To prevent this. X2 . Of course.. the sum of the variances of all of the principal components will equal the sum of the variances of all of the variables.. The elements in the diagonal of matrix Sy. . all of these transformations of the original variables to the principal components is Y = AX.. The first principal components (Y1 ) is given by the linear combination of the variables X1 . Collectively. equal to the original number of variables. one could make the variance of Y1 as large as possible by choosing large values for the weights a11 .. a12 . the data are first centered on the means of each variable. that is. Xp : Y1 = a11 X1 + a12 X2 + .e.a1p . the variance covariance matrix of 41 . with the condition that it is uncorrelated with (i. ... Y2 = a21 X1 + a22 X2 + .. The rows of matrix A are called the eigenvectors of variance-covariance matrix of the original data. + a2p Xp . + a1p Xp . all of the original information has been explained or accounted for. and are also known as loadings.. This continues until a total of p principal components have been calculated.3 Principal component analysis Given a data matrix with p variables and n samples.. and is calculated in such a way that it accounts for the greatest possible variance in the data set. + a2 = 1.

4.0985 0.0008 0. each principal component is constructed in such a way that variance is maximized.0145 0. Standard deviation Proportion of Variance Cumulative Proportion PC1 2. Supply variables (refinery 42 .711 0.5 shows the results for 11 principal components. In our particular case the first principal component P C1 explains 71 % of varinace of the data set.9998 PC11 0. Table 4. In the following the analysis will be based on these 7 fundamentals rather than on all the factors selected initially. while principal components P C1.804 PC3 1.8408 0.711 PC2 1.0080 0. Based on the results of the principal components analysis 7 main factors are chosen among all 11 factors considered.1843 0.882 PC4 1. factors described above are used to build 11 principal components that may be represented as a linear combination of initial factors.999 PC10 0. P C3 together account for 88 % of the total variance in the data set. 7 factors that are located as close as possible to the P C1 axis are chosen.0323 0.4344 0. In order to do so.6479 0.6 and 4.7.24812 0. Results of regression estimation are presented in Tables 4.093 0. According to the method.9917 PC8 0. The choice is made by simple eyeballing by taking into consideration the fact that the distance between each single factor and a chosen axis should be minimal.512 0. are known as the eigenvalues.3. Once the dimension of the data set is reduced.2 Empirical results Ideas of principal component analysis can be applied to determine what are the factors that can explain variations of crude oil prices.637 0.6 gives evidence that use of principal component analysis substantially improves the results.4. Now almost all estimators are significance. Table 4.3 Principal component analysis the principal components.0544 0.9360 PC5 0. positive sign of such factors as demand.9828 PC7 0. we examine an impact of the selected factors on crude oil prices and returns.099 0. P C2. 4 months future contract price and S&P index confirm our hypotheses about positive impact of these variable on crude oil spot price.0026 0.9964 PC9 0. Since the first principal component explains around 70 % of the total variance of the data set.0002 1.007 0.9683 PC6 0.0000 Table 4. Eigenvalues are the variance explained by each principal component and are constrained to decrease monotonically from the first principal component to the last.1 presents factors depicted in P C1 − P C2 coordinate system.0047 0.5: Principal Component Analysis Figure 4.3397 0.078 0.

004647 0.000428 0.003778 -0.1: Plot of factors in PC1-PC2 coordinate system .0003 0.627588 -3.472991 -1.02E-18 8. WTI crude oil spot price.056276 0.014414 -0.914172 p-value 1.18246 0.000874 -0.807135 8.000313 1.36E-12 1012 0.43185 0.02E-05 0.508919 218.000291 -0.995 Number of observations R2 Table 4.factors corresponding to the points lying along with the horizontal axis are assumed to be fundamental factors WTI crude oil price spot prices coefficient const DEM CAP RIGS F4 INT SP GDP 18.131634 0 0.001129 standard error 3.000537 0.000252 0.6: Estimation of linear regression model with the reduced set of fundamental factors.841397 3. 43 .000163 t-statistic 4.3 Principal component analysis Figure 4.4.3132 -3.242213 8.49E-06 0.001225 5.000207 0.819145 -6.

11467 3.00061 0.00039 t-statistic 3. Effect of GDP seems to be somewhat surprising: its estimator is negative implying that there is a negative trade-off between the value of gross domestic product and oil prices.18171 p-value 0. as it was discussed previously.00019 0. In our analysis forecasts for n = 40.00024 -0.20984 1.4. 44 . As of the dynamics of oil price returns.57946 -4.16471 0. WTI crude oil price returns coefficient const DEM CAP RIGS F4 INT SP GDP 28.00152 0.0285 Number of observations R2 Table 4.12579 1. results of estimation suggest that mainly supply factors influence their behavior: refinery capacity and number of rigs are two significant supply variables with a negative impact on crude oil returns.00152 -0.4 4.4 Forecasting and comparison capacity and number of rigs) have a negative effect on prices.4.0005 0.01004 4.01119 0.17935 0. 4.1 Forecasting and comparison Forecasting returns series Estimated parameters of the linear regression can be used to construct a forecast assuming that all the necessary factors are known.00182 0.83384 0.47861 -1. the same frequency is also used for parameter esimtaion procedure applied to the time series models.2088 0. 10 are built and compared to corresponding forecasts obtained from time series models presented above.02843 0. Estimation of parameters is performed on in-sample data and forecast is made for the rest of observations and compared to the actual data corresponding to this time period.00205 0.13956 0.2E-05 0.7: Estimation of linear regression model with the reduced set of fundamental factors.00103 0. WTI crude oil returns.8. As a basis for comparison such forecast performance measures as MSE and MAD are used. Results can be found in the Table 4.2376 1012 0.25768 -2.00156 -0. 20.13547 0.00046 standard error 9.03556 0. as well as the interest rate. Since the frequency of data used to determine the fundamental factors is weekly.6469 0.

02374860 0. ARMA(1. we are interested in forecasting not only returns series. It is done in the following way: first 7 selected factors are added to the mean equation described by the ARM A(1.02378043 0.024970522 0.04245880 EGARCH 0.04245805 Factors 0.001556476 1.4.481004e-05 0.0028) V6 0.0899) ma1 0.013*** (0.9).029540268 Table 4.001045355 0.001556191 1. Results of estimation 45 . which indicates that linear regression model of returns series performs better than various time series models.0031) V4 0. 4.001556337 1.0764) intercept 0.0031) V5 0.04245410 APARCH 0.0009749707 0.1) with external regressors.0040) V7 -0. the forecasts that are based on the linear regression model are characterized by the lowest values of MSE and MAD almost for all considered forecasting horizons.03126629 0.0009752605 0.004** (0. Results of comparison.03128204 0.8.0028) V2 -0.001504633 0.9: Modelling weekly WTI returns: mean equation ARMA(1.03127564 0.4.0056) V3 -0.4 Forecasting and comparison Returns GARCH MSE 10 20 40 MAD 10 20 40 0.02376722 0.693*** (0.020689527 0.0074) Table 4.2 Forecasting volatility Based on the results of the previous section we conclude that it may make sense to include selected factors as external regressors in order to improve the accuracy of forecasts.015*** (0.02376477 0.000717371 0.481004e-05 0. but also conditional volatility.552*** (0.1) with external regressors ar1 -0.03127441 0.001556359 1. 1) (see Table 4.006** (0.009** (0. However. then parameters of four models of conditional volatility are estimated using the usual procedure and forecast performance measures are computed (see Table 4. According to the Table 4.481004e-05 0.0006 (0.011*** (0.0014) V1 0.04246252 GJR-GARCH 0.0009753049 0.001 (0.481004e-05 0.8: Forecast of returns series.0009755459 0.11).

998919 40. Mean equation ARMA(1.178011e-06 6.03483 5.001209904 0.242845e-06 0.229685e-06 0.001226605 0.77909 0.273180e-06 GJR-GARCH 1.001703925 7.001695993 8.001790515 1.4.699623 7.001198018 0.725124e-06 2.88312 27.4 Forecasting and comparison GARCH MSE 10 20 40 MAD 10 20 40 QLIKE 10 20 40 R2LOG 10 20 40 5.176375e-06 0.001740749 1.698564 7.152935 EGARCH 1.150143 6.638722 7.69147 5.252697e-06 GJR-GARCH 1.001256519 0.663473 7.001685312 9.532729e-06 2.447323 8.20963 5.001225348 0.308943 6.001699521 7.093317e-06 6.11: Modelling weekly WTI returns: mean equation ARMA(1.001202221 0.025813e-06 6.10: WTI returns.090884 6.75115 5.518638e-06 2.227854e-06 0.001136795 0.001704235 7.951330 7.82546 26.001216589 0.117136 6.207705 6.740230e-06 2.926220 38.001139979 0.612724 7.163844e-06 0.159161 EGARCH 1.55618 30.163711 Table 4. Forecast performance measures 46 .139567 40.10286 26.001202223 0.169439 39.540868e-06 2.50314 25.053292 38.001149370 0.10412 26.1) without external regressors and four models of conditional variance.058361e-06 6.665262 7.136302 APARCH 1.159177 Table 4.106061 6.092730 6.001219098 0.033588e-06 6.162839e-06 0. four models of conditional variance.1) with external regressors. Forecast performance measures GARCH MSE 10 20 40 MAD 10 20 40 QLIKE 10 20 40 R2LOG 10 20 40 5.16065 5.075371e-06 6.902191 38.500587e-06 2.876753 39.517961e-06 2.001144428 0.24834 0.70198 26.001713302 8.001249980 0.06326 5.001130764 0.284573 6.272863 7.978434 7.001149439 0.717529 38.135187e-06 6.215167 APARCH 1.091572e-06 6.56881 26.544896e-06 2.

EGARCH and APARCH). model based on these fundamental factors is not able to capture the volatility of crude oil markets as successfully as time series models. superiority of APARCH model for WTI crude oil market in the sense of forecast accuracy is consistent with the results obtained in the previous chapter. GJR-GARCH. while refinery capacity and interest have a negative influence on their dynamics. price of future contracts and S&P index have a positive impact on spot prices series.11 and 4. moreover. Use of these fundamental factors allows us to effectively model dynamics of crude oil returns. 7 fundamental factors explaining dynamics of weekly WTI crude oil spot prices were selected.5 Summary As a result of analysis presented in this chapter.4. forecast accuracy was not improved by adding external factors to time series models.5 Summary Comparing results presented in Tables 4. However. 47 . As of returns series. such as refinery capacity and number of operating rigs. It was shown that such factors as volume of US demand for crude oil.10 for WTI crude oil market we come to a conclusion that contrary to our expectations. 4. forecast performance of such a model is shown to be superior to performance of four commonly used models of conditional variance (GARCH. However. fundamental factors are mainly related to features of the supply side.

three other models were used as well: GJR-GARCH(1. with the aim of examining whether or not shocks have asymmetric and persistent effects on oil price volatility. however it is outperformed by models of conditional volatility in the sense of out-of-sample volatility forecasts. Our finding confirms these hypotheses and suggest that shocks have permanent and asymmetric effects on volatility for both markets considered. APARCH model for WTI and GJR-GARCH for Brent crude oil market provide superior performance in out-of-sample volatility forecasts. which make examination of their dynamics particularly significant.1). a set of possible factors affecting WTI oil prices was examined and the most important fundamental factors were sorted out. EGARCH(1.1) and APARCH(1. especially prices of crude oil. Moreover. In order to capture specific features of crude oil markets we first analyzed different conditional heteroskedasticity models. have considerable macroeconomic and microeconomic impacts. The model based on these factors gives a good fit for crude oil returns. The goal of this project was to examine crude oil price behavior.1) model.5 Concluding remarks Commodity prices. Furthermore. which allow to model dynamics of oil price returns. 48 . Among four models GJR-GARCH and APARCH models capture persistence better than GARCH and EGARCH models.1). In addition to the traditional GARCH(1. compare different models of forecasting its volatility and determine fundamental factors explaining its dynamics.

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