Modeling of Oil Prices

The paper derives a parsimonious two-component affine diffusion model with one driving Brownian motion to capture the dynamics of oil prices. It can be observed that the oil price behaves in some sense similarly to the US dollar. However, there are also clear differences. To identify these the paper studies the empirical features of an extremely well diversified world stock index, which is a proxy of the numeraire portfolio, in the denomination of the oil price. Using a diversified index in oil price denomination allows us to disentangle the factors driving the oil price. The paper reveals that the volatility of the numeraire portfolio denominated in crude oil, increases at major oil price upward moves. Furthermore, the log-returns of the index in oil price denomination appear to follow a Student-t distribution. These and other stylized empirical properties lead to the proposed tractable diffusion model, which has the normalized numeraire portfolio and market activity as components. An almost exact simulation technique is described, which illustrates the characteristics of the proposed model and con?rms that it matches well the observed stylized empirical facts.