Working Paper: CEPR ID: DP10162
Authors: Christiane Baumeister; Lutz Kilian
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 timevarying 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: Forecast; Futures; Market Expectation; Model Uncertainty; Oil Price; Risk Premium
JEL Codes: C53; D84; G14; Q43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| risk premium (G19) | risk-adjusted futures price (G13) |
| risk-adjusted futures price (G13) | market expectations (D84) |
| risk premium (G19) | estimation of market expectations (G17) |
| risk-adjusted futures price (G13) | mean squared prediction error (MSPE) (C51) |
| risk premium estimate credibility (D81) | mean squared prediction error (MSPE) comparison with unadjusted futures price (C53) |
| risk premium estimates (G19) | accuracy of expectations measure (D84) |
| new measure of oil price expectations (Q47) | predictive power (C52) |