The Fundamental, Speculative and Macroeconomic Determinants of Variance and Skew Risk Premia in Oil Market

Abstract

Using the model-independent approaches of Trolle and Schwartz (2008) and Kozhan et al (2013), we estimate the Variance Risk Premium and Skew Risk Premium for oil market. After estimation, the contribution of the paper is twofold. First, we try to figure out which variables can describe the variation in variance and skew risk premium and the risk-neutral Skewness. The results show that we are able to describe a considerable portion of the variation in all three variables using speculative and macroeconomic factors and most of the variation is being described by by the latter group of variables. We also try to capture the effect of fundamentals of oil market on these variables. The results show that the fundamentals are able to describe big portion of variation in these three variables. Second, we try to predict the return of delta-hedged and delta-vega hedged option portfolios and also oil futures return. The results show that variance risk premium is a significant predictor of delta-hedged portfolio cumulative return with a positive sign while skew risk premium can describe the cumulative return of the delta-Vega Hedged portfolio with negative sign. The results also show that both variance and skew risk premia are significant predictors of cumulative futures return with different signs.

Keywords: Variance Risk, Skewness Risk, Option-Implied Momemnts, Oil Fundamentals, Macroeconomic, Speculative

JEL Classification: G11; G12; G13