Analyzing Oil Futures with a Dynamic Nelson-Siegel Model

ABSTRACT In this paper we are interested in the term structure of futures contracts on oil. The objective is to specify a relatively parsimonious model which explains data well and performs well in out of sample forecasting. The dynamic Nelson-Siegel model is normally used to analyze and forecast interest rates of different maturities. The structure of oil futures resembles the structure of interest rates and this motivates the use of this model for our purposes. The Dynamic NelsonSiegel model allows for a significant dimension reduction by introducing three factors. By performing a series of cross-section regressions we obtain time series for these factors and we focus on modeling their joint distribution. Using a copula decomposition we can set up a model for each factor individually along with a model for their dependence structure. When a reasonable model for the factors has been specified it can be used to forecast prices of futures contracts with different maturities. The outcome of this exercise is a model which describes the observed futures contracts well and forecasts better than conventional benchmarks. The model is flexible and is expected to work well for other energy based commodities