temporal behaviour of volatility of daily returns on crude oil futures using a generalised regime switching model that allows for abrupt changes in mean and variance,

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Abstract

This paper examines the temporal behaviour of volatility of daily returns on crude oil

futures using a generalised regime switching model that allows for abrupt changes in mean

and variance, GARCH dynamics, basis-driven time-varying transition probabilities and

conditional leptokurtosis. This flexible model enables us to capture many complex features

of conditional volatility within a relatively parsimonious set-up. We show that regime shifts

are clearly present in the data and dominate GARCH effects. Within the high volatility

state, a negative basis is more likely to increase regime persistence than a positive basis, a

finding which is consistent with previous empirical research on the theory of storage, e.g.

Fama and French 1988a,b and Ng and Pirrong 1994 . The volatility regimes identified by Ž . Ž.

our model correlate well with major events affecting supply and demand for oil. Out-of-sample tests indicate that the regime switching model performs noticeably better than nonswitching models regardless of evaluation criteria. We conclude that regime switching

models provide a useful framework for the financial historian interested in studying factors

behind the evolution of volatility and to oil futures traders interested short-term volatility

forecasts.
2002 Elsevier Science B.V. All rights reserved.

Keywords: Crude oil futures; Conditional volatility; GARCH; Markov switching

1. Introduction

Empirical studies indicate that commodity prices can be extremely volatile at

times. Webb 1987 describes such occasional outburst of volatility as indications of Ž .

a ‘choppy’ market. According to Webb 1987 : Ž ..

Corresponding author.

0140-988302$ - see front matter
2002 Elsevier Science B.V. All rights reserved.

PII: S 0 1 4 0 - 9 8 8 3 0 1 Ž . 00087-1

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