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

Miguel Herce, John E. Parsons and Robert C. Ready

April 2006

Miguel Herce, John E. Parsons and Robert C. Ready, April 2006

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 na´ve 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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