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

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  • Miguel Herce
  • John E. Parsons
  • Robert C. Ready
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    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 naïve 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.

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    Bibliographic Info

    Paper provided by Massachusetts Institute of Technology, Center for Energy and Environmental Policy Research in its series Working Papers with number 0605.

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    Date of creation: Apr 2006
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    Handle: RePEc:mee:wpaper:0605

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