Risk Premia in the Term Structure of Crude Oil Futures: Long-Run and Short-Run Volatility Components

Abstract

This paper studies how volatility affects the risk premium in crude oil futures through a discrete-time term structure model with long-run and short-run GARCH-type volatility components. Estimated using WTI crude oil futures data from January 1990 to July 2016, our model simultaneously matches futures prices and volatilities for the nearest twelve maturities. We document a significant positive relation between volatility and futures risk premia before May 2005, but a significant negative relation after that. The dynamic change of the risk-return relationship concur with the structural change, specifically the financialization, in the commodity markets. Risk premia decomposition indicates that the short-run volatility component represents the most important contribution to futures risk premia, both before and after the structural break.

Keywords: commodity futures, term structure models, volatility components, long-run and short-run, GARCH, futures risk premium

JEL Classification: G12, G13