Crude Oil Price Dynamics with Crash Risk Under Fundamental Shocks

North American Journal of Economics and Finance, 54 (2020), 101238

52 Pages Posted: 17 Apr 2020 Last revised: 8 Jul 2020

See all articles by Cho-Hoi Hui

Cho-Hoi Hui

Hong Kong Monetary Authority - Research Department

Chi-Fai Lo

The Chinese University of Hong Kong

Chi-Hin Cheung

affiliation not provided to SSRN

Andrew Wong

Hong Kong Monetary Authority

Multiple version iconThere are 2 versions of this paper

Date Written: June 4, 2020

Abstract

Our paper presents a crude oil price model in which the price is confined in a wide moving band. A price crash occurs when the price breaches the lower boundary where a smooth-pasting condition is imposed. Using an asymmetric mean-reverting fundamental (supply/demand) shock, the solution derived from the oil price equation for the model shows the oil price follows a mean-reverting square-root process, which is quasi-bounded at the boundary. The oil price dynamics generates left-skewed price distributions consistent with empirical observations. A weakened mean-reverting force for the price increases the probability leakage for the price across the boundary and the risk of a price crash. The empirical results show the oil price dynamics can be calibrated according to the model, where the mean reversion of the price dynamics is positively co-integrated with the oil production reaction to negative demand shocks, and with the risk reversals of the commodity currencies, the Canadian dollar and the Australian dollar in currency option markets. The results are consistent with an increased price crash risk with negative demand shocks and negative risk reversals. The forecasting performance of the oil price model is better than the futures-spread models and random walk models during the crash periods. While the price of oil was above the lower boundary for most of the time, the conditions for breaching the boundary were met in 2008 and 2014 when the price fell sharply.

Keywords: Target zone; quasi-bounded process; crude oil, OPEC; oil demand shocks

JEL Classification: F31, G13

Suggested Citation

Hui, Cho-Hoi and Lo, Chi-Fai and Cheung, Chi-Hin and Wong, Andrew, Crude Oil Price Dynamics with Crash Risk Under Fundamental Shocks (June 4, 2020). North American Journal of Economics and Finance, 54 (2020), 101238, Available at SSRN: https://ssrn.com/abstract=3550929 or http://dx.doi.org/10.2139/ssrn.3550929

Cho-Hoi Hui (Contact Author)

Hong Kong Monetary Authority - Research Department ( email )

Hong Kong
China

Chi-Fai Lo

The Chinese University of Hong Kong ( email )

Department of Physics
Shatin, N.T., Hong Kong
China

Chi-Hin Cheung

affiliation not provided to SSRN

Andrew Wong

Hong Kong Monetary Authority ( email )

3 Garden Road, 30th Floor
Hong Kong
Hong Kong

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