Estimating Oil Risk Factors Using Information from Equity and Derivatives Markets

Abstract

We introduce a novel approach to estimating latent oil risk factors and establish their significance in pricing non-oil securities. Our model, which features four factors with simple economic interpretations, is estimated using both derivative prices and oil-related equity returns. The fit is excellent in and out of sample. The extracted oil factors carry significant risk premia, and are significantly related to macroeconomic variables as well as portfolio returns sorted on characteristics and industry. The average non-oil portfolio exhibits a sensitivity to the oil factors amounting to a sixth (in magnitude) of that of the oil industry itself.

Keywords: Oil, futures, asset pricing, APT, real options, CAPM, Fama-French factors, Markov chain Monte Carlo

JEL Classification: G12, G13