Oil Market Modelling: A Comparative Analysis of Fundamental and Latent Factor Approaches
34 Pages Posted: 31 May 2016
Date Written: May 28, 2016
We formally compare fundamental factor and latent factor approaches to oil price modelling. Fundamental modelling has a long history in seeking to understand oil price movements, while latent factor modelling has a more recent and limited history, but has gained popularity in other financial markets. The two approaches, though competing, have not formally been compared as to effectiveness. For a range of short- medium- and long-dated WTI oil futures we test a recently proposed five-factor fundamental model and a Principal Component Analysis latent factor model. Our findings demonstrate that there is no discernible difference between the two techniques in a dynamic setting. We conclude that this infers some advantages in adopting the latent factor approach due to the difficulty in determining a well specified fundamental model.
Keywords: oil futures, fundamental models, latent factors, Vuong model comparison
JEL Classification: C32, G13, Q41
Suggested Citation: Suggested Citation