The State Price Density Implied by Crude Oil Futures and Option Prices

Abstract

We show that both large oil price increases and decreases are associated with deteriorating economic conditions. This suggests that the projection of the state price density (SPD) on oil returns should display a U-shaped pattern and that is indeed the result when estimating it from oil futures and options prices. Furthermore, when economic conditions deteriorate, the U-shaped SPD becomes steeper in both tails so that investors assign higher state prices to very low and very high oil returns. Finally, we find that an increase in economic activity lowers the representative agent's relative risk aversion towards oil price changes.

Keywords: State price density; macroeconomic condition; crude oil; risk aversion

JEL Classification: G12, G13