Oil market modelling: A comparative analysis of fundamental and latent factor approaches

Abstract : We formally compare fundamental factor and latent factor approaches to oil price modelling. Fundamental modelling has a long history in seeking to understand oil price movements, while latent factor modelling has a more recent and limited history, but has gained popularity in other financial markets. The two approaches, though competing, have not formally been compared as to effectiveness. For a range of short-medium-and long-dated WTI oil futures we test a recently proposed five-factor fundamental model and a Principal Component Analysis latent factor model. Our findings demonstrate that there is no discernible difference between the two techniques in a dynamic setting. We conclude that this infers some advantages in adopting the latent factor approach due to the difficulty in determining a well specified fundamental model.
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Mark Cummins, Michael Dowling, Fearghal Kearney. Oil market modelling: A comparative analysis of fundamental and latent factor approaches. International Review of Financial Analysis, Elsevier, 2016, Vol. 46, pp. 211-218. ⟨10.1016/j.irfa.2016.05.010⟩. ⟨hal-01387596⟩

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