Estimating Oil Risk Factors Using Information from Equity and Derivatives Markets

Authors:
  • ICI‐Hsuan Ethan Chiang
    I‐Hsuan Ethan Chiang
  • WHW. Keener Hughen
    W. Keener Hughen
  • JSJacob S. Sagi
    Jacob S. Sagi
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Abstract
We introduce a novel approach to estimating latent oil risk factors and establish their significance in pricing nonoil securities. Our model, which features four factors with simple economic interpretations, is estimated using both derivative prices and oil‐related equity returns. The fit is excellent in and out of sample. The extracted oil factors carry significant risk premia, and are significantly related to macroeconomic variables as well as portfolio returns sorted on characteristics and industry. The average nonoil portfolio exhibits a sensitivity to the oil factors amounting to a sixth (in magnitude) of that of the oil industry itself.

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