Using Futures Prices to Filter Short-Term Volatility and Recover a Latent, Long-Term Price Series for Oil

MIT Center for Energy and Environmental Policy Working Paper No. 06-005

29 Pages Posted: 13 Jun 2008

See all articles by John E. Parsons

John E. Parsons

Massachusetts Institute of Technology (MIT) - Sloan School of Management

Miguel Herce

CRA International, Inc.

Robert C. Ready

University of Oregon - Department of Finance

Date Written: April 1, 2006

Abstract

Oil prices are very volatile. But much of this volatility seems to reflect short-term, transitory factors that may have little or no influence on the price in the long run. Many major investment decisions should be guided by a model of the long-term price of oil and its dynamics. Data on futures prices can be used to filter out the short-term volatility and recover a time series of the latent, long-term price of oil. We test a leading model known as the 2-factor or short-term, long-term model. While the generated latent price variable is clearly an improvement over the raw spot oil price series, we also find that (1) the generated long-term price series still contains some of the short-term volatility, and (2) a naĆ½ve use of a long-maturity futures price as a proxy for the long-term price successfully filters out a large majority of the short-term volatility and so may be convenient alternative to the more cumbersome model.

Keywords: oil price, volatility, futures

JEL Classification: L71, G13

Suggested Citation

Parsons, John E. and Herce, Miguel and Ready, Robert C., Using Futures Prices to Filter Short-Term Volatility and Recover a Latent, Long-Term Price Series for Oil (April 1, 2006). MIT Center for Energy and Environmental Policy Working Paper No. 06-005, Available at SSRN: https://ssrn.com/abstract=905009 or http://dx.doi.org/10.2139/ssrn.905009

John E. Parsons (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

HOME PAGE: http://www.mit.edu/~jparsons/

Miguel Herce

CRA International, Inc. ( email )

1201 F. St. NW
Ste. 700
Washington, DC 20004
United States

Robert C. Ready

University of Oregon - Department of Finance ( email )

Lundquist College of Business
1208 University of Oregon
Eugene, OR 97403
United States

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
135
Abstract Views
876
rank
263,372
PlumX Metrics