Oil Price Dynamics and Speculation: A Multivariate Financial Approach

28 Pages Posted: 4 Nov 2008

See all articles by Giulio Cifarelli

Giulio Cifarelli

DISEI University of Florence

Giovanna Paladino

IntesaSanpaolo; LUISS Economics Department

Date Written: November 4, 2008

Abstract

This paper assesses empirically whether speculation affects oil price dynamics. The growing presence of financial operators in the oil markets has led to the diffusion of trading techniques based on extrapolative expectations. Strategies of this kind foster feedback trading that may cause large departures of prices from their fundamental values. We investigate this hypothesis using a modified CAPM that follows Shiller (1984) and Sentana and Wadhwani (1992). At first, a univariate GARCH(1,1)-M is estimated assuming that the risk premium is a function of the conditional oil price volatility. The single factor model, however, is outperformed by the multifactor ICAPM (Merton, 1973) which takes into account a larger investment opportunity set. The analysis is then carried out using a trivariate CCC GARCH-M model with complex nonlinear conditional mean equations where oil price dynamics are associated with both stock market and exchange rate behavior. We find strong evidence that oil price shifts are negatively related to stock price and exchange rate changes and that a complex web of time varying first and second order conditional moment interactions affect both the CAPM and feedback trading components of the model. Despite the difficulties, we identify a significant role of speculation in the oil market which is consistent with the observed large daily upward and downward shifts in prices. A clear evidence that it is not a fundamentals-driven market. Thus, from a policy point of view - given the impact of volatile oil prices on global inflation and growth - actions that monitor more effectively speculative activities on commodity markets are to be welcomed.

Keywords: oil price dynamics, feedback trading, speculation, multivariate

JEL Classification: G11, G12, G18, Q40

Suggested Citation

Cifarelli, Giulio and Paladino, Giovanna, Oil Price Dynamics and Speculation: A Multivariate Financial Approach (November 4, 2008). Available at SSRN: https://ssrn.com/abstract=1295353 or http://dx.doi.org/10.2139/ssrn.1295353

Giulio Cifarelli

DISEI University of Florence ( email )

via delle Pandette 9
Florence 50127
Italy

Giovanna Paladino (Contact Author)

IntesaSanpaolo ( email )

Piazza San Carlo
Torino, 10121
Italy

LUISS Economics Department ( email )

Viale di Villa Massimo, 57
Rome, 00161
Italy

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