A General Approach to Recovering Market Expectations from Futures Prices with an Application to Crude Oil

58 Pages Posted: 23 Sep 2014

See all articles by Christiane Baumeister

Christiane Baumeister

University of Notre Dame

Lutz Kilian

University of Michigan at Ann Arbor - Department of Economics; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 3 versions of this paper

Date Written: September 13, 2014

Abstract

Futures markets are a potentially valuable source of information about market expectations. Exploiting this information has proved difficult in practice, because the presence of a time-varying risk premium often renders the futures price a poor measure of the market expectation of the price of the underlying asset. Even though the expectation in principle may be recovered by adjusting the futures price by the estimated risk premium, a common problem in applied work is that there are as many measures of market expectations as there are estimates of the risk premium. We propose a general solution to this problem that allows us to uniquely pin down the best possible estimate of the market expectation for any set of risk premium estimates. We illustrate this approach by solving the long-standing problem of how to recover the market expectation of the price of crude oil. We provide a new measure of oil price expectations that is considerably more accurate than the alternatives and more economically plausible. We discuss implications of our analysis for the estimation of economic models of energy-intensive durables, for the debate on speculation in oil markets, and for oil price forecasting.

Keywords: futures, risk premium, market expectation, model uncertainty, forecast, oil price

JEL Classification: C53, D84, G14, Q43

Suggested Citation

Baumeister, Christiane and Kilian, Lutz, A General Approach to Recovering Market Expectations from Futures Prices with an Application to Crude Oil (September 13, 2014). CFS Working Paper, No. 466. Available at SSRN: https://ssrn.com/abstract=2499484 or http://dx.doi.org/10.2139/ssrn.2499484

Christiane Baumeister

University of Notre Dame ( email )

722 Flanner Hall
Notre Dame, IN 46556
United States
+1 574 631 8450 (Phone)

HOME PAGE: http://https://sites.google.com/site/cjsbaumeister/

Lutz Kilian (Contact Author)

University of Michigan at Ann Arbor - Department of Economics ( email )

611 Tappan Street
Ann Arbor, MI 48109-1220
United States
734-764-2320 (Phone)
734-764-2769 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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