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TABLE OF CONTENTS
CHAPTER 1 INTRODUCTION…..……………………………………………………. 3
1.1 Overview of the study ……………………………………………………………………………………………………..3
1.2 Problem Statements …………………………………………………………………………………………………………6
1.3 Objective of the Study ……………………………………………………………………………………………………..6
CHAPTER 2 LITERATURE REVIEW ………………………………………………7
2.1 Introduction of Smooth Transition Exponential Smoothing (STES) …………………………………7
2.2 Previous studies about Crude oil ………………………………………………………………………………………9
2.3 Previous studies about gold ………………………………………………………………………………………….…12
2.4 Previous Studies about the relationship between gold and crude oil ………………………….……14
2.5 Realized Volatility ………………………………………………………………………………………………………...15
2.6 SUMMARY ……………………………………………………………………………………………………………….….16
CHAPTER 3 DATA AND METHODOLOGY ……………………………………..….16
3.1 Data ………………………………………………………………………………………………………………………….…….16
3.2 Methodology …………………………………………………………………………………………………………….…….17
3.2.1 General …………………………………………………………………………………………………………….……..17
3.2.2 Ad Hoc Volatility models ………………………………………………………………………………….…….19
3.2.2.1 Adaptive Smooth Transition Exponential Smoothing (STES) …………………….……….19
3.2.3 GARCH Models …………………………………………………………………………………………….………..22
3.2.3.1 GARCH (1,1) …………………………………………………………………………………………….………..22
3.2.3.1.1 Regressor …………………………………………………………………………………………….…………23
3.2.3.1.1.1 Crude oil Vs Gold …………………………………………………………………….….……..….23
3.2.3.2 IGARCH ………………………………………………………………………………………………….………….24
3.2.3.3 POWER ARCH (PARCH) ……………………………………………………………………….………….24
3.2.3.4 EGARCH ……………………………………………………………………………………………………….……25
3.2.3.5 GJR (Threshold GARCH) ……………………………………………………………………………….…..26
CHAPTER 4 Empirical Results & Discussion ……………………………………….….27
4.1 In-Sample Estimation ……………………………………………………………………………………………………..27
4.2 Out-Sample Forecasting results ……………………………………………………………………………………….30
CHAPTER 5 CONCLUSION AND IMPLICATION ………………………………….35
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CHAPTER 1 INTRODUCTION
1.1 Overview of the study
In recent years, commodities have receiving increase attention from investors, traders, policy
makers, speculators and producers. The significant large investments have flowing into the
commodity markets, particular crude oil and gold. This is mainly driven by the flare up of
price especially crude oil of which had reached the near record-high in July 2008, increase in
their economic uses and inelastic high global demand resulted from the speedily increase of
markets. It is well known that, the supply of commodities are highly inelastic and the large
demand shocks can easily lead to big swings in spot and future price over the short run.
Hence, it is right to say that, commodities are susceptible to sudden and large volatility
swings, especially crude oil (Wilson et la., 1996). Volatility is a measure of average deviation
from the mean. In the financial markets, volatility is associating with risk and uncertainty
which are the key attributes in investing, option pricing and risk management. Volatility
plays the same role in commodity markets for commodity investment portfolio determination,
physical commodities pricing and risk management. Since the magnitude of volatility in
commodity markets is much higher than financial market, the risk associate with investment
is relatively high. To ensure the risk is well managed, it is crucial and fundamental to predict
The volatility forecasting models being used so far in commodity markets are implied
standard deviation (Namit, 1998), ARCH-type models (Foong and See, 2002; Giot and
Lauretn, 2003; Chin W.C, 2009), asymmetric threshold autoregressive (TAR) model (Godby
et al., 2000), and artificial based forecast methods (Fan et al., 2008; Moshiri, 2004); CAViaR
approach (Huang et al., 2009) However, the complexity of the model specification does not
3
guarantee high performance on out-performed out-of-sample forecasts. Sadorsky (2006)
found that the out-of-sample forecast of a single equation generalized ARCH model is more
superior to those of state space, vector autoregression and bivariate GARCH models in
predicting the price of petroleum futures. Among the ample forecasting methods, no model is
a clear winner. Different methods may be capturing the information set differently, and which
method is superior may depend on market conditions. In this paper, we would like to
introduce a new adaptive method namely Smooth Transition Exponential Smoothing (STES)
which was recommended by James W. Taylor in 2004. This approach was used in equity
markets with encouraging results. However, to our knowledge, it has not yet been applied in
commodity markets.
With STES method, we are going to examine the out-of-sample volatility forecasts for crude
oil and gold. This method allows the smoothing parameter to vary as a logistic function of
user-specified variables. The parameters in this method will then be optimised by minimising
the sum of squared in-sample one-step-ahead prediction errors, where prediction error is
defined as the difference between realized and forecast volatility. In our empirical work here,
we propose to use square error term and realized volatility separately as actual variance to
optimise the prediction error, we compare the accuracy of volatility forecasts between these 2
different types of prediction errors. Since the daily data is available, we estimate the
parameters for daily prediction error and sum up 5-day prediction error on weekly basis to
compare with actual weekly volatility forecasts. The predictive power of STES will then
compare with variants of GARCH models with the predictive criterion of RMSE.
In view of the higher volatility found in the commodity markets, we would like to examine
every possible information that contribute to the return volatility of commodity products in
4
attempt to improve the prediction accuracy. In this premises, we proposed to examine
significant impacts of a crude oil return to the return volatility of gold. The purpose of this
examination is to test the role play by the return of crude oil as a regressor to improve the
return volatility forecasts of gold. We would like to find out does the information of gold can
explain the changes in the return volatility of crude oil and vice versa. The reason lies for this
test is that crude oil and gold has the most powerful historical commodity interrelationships.
Gold and crude oil prices tend to rise and fall in synchronicity with one another. One reason
is that, historically, oil purchases were paid for in gold. Even today, a sizeable percentage of
oil revenue ends up being invested in gold. As oil price rise, much of the increased revenue,
considered as surplus to current needs, is invested, and much of this is invested in gold or
other hard assets. Another reason is that rising oil prices place upward pressure on inflation
and this enhances the appeal of gold because it acts as an inflation hedge. Hence, crude oil
and gold are the most widely traded commodities. They are commodities that priced in US
dollar and are included in the commodity portfolios of most serious individual and
institutional investors. Investors switch between oil and gold or combine them in diversified
portfolios.
In the next section, we review the literature of volatility forecasting methods which have been
used in commodity markets; introduce the application of new adaptive exponential smoothing
methods. In the third section, we will describe the data and methodologies use in this study.
The forth section, we exhibit in-sample and out-of-sample empirical results to compare the
forecasting accuracy of the new method with variants GARCH models. The final section
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1.2 Problem Statements
To initiate the study, there are some problem statements which needed to be structured in
was modelled by James W. Taylor (2004). It has been proven performed well with
encouraging results for 8 stock indices. This model has never been applied in
forecast equally well in commodity market and hence superior than variants GARCH?
- High-frequency data provide more accurate estimates for actual volatility and provide
more accurate volatility forecasts than low-frequency data. Can weekly realized
volatility which constructed from the accumulation of 5 trading days squared errors
terms act as a better proxy of actual variance to out-performed actual weekly squared
error terms?
- To what extent does crude oil or gold price impacted to the return volatility of each
other? Can the existence of gold explain the changes in return volatility of crude oil
• The objective of this paper is to compare the predictive accuracy of ad hoc method
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• To investigate the information contains in high-frequency data explainable to the
• To investigate the significant impact of ε t,CO-1 of crude oil as regressor to the return
volatility of gold and vice versa. Does existence of crude oil return improve the
volatility model to the established adaptive exponential smoothing model meant to improve
its application. It has overcome the problem of deliver unstable forecast found in established
exponential smoothing model, there have been many different attempts to avoid instability of
forecasts by enabling the exponential smoothing parameters to adapt over time according to
the characteristics of the series. This is conformed to William (1987) suggestion that only the
smoothing parameter for the level should be adapted in order to avoid instability. Among all
the proposals presented, there is no consensus as to the most useful adaptive approach except
Trigg and Leach (1967) model has been recognized as a best known and most widely-used
procedure. Their method defines the smoothing parameters as the absolute value of the ratio
of the smoothed forecast error to the smoothed absolute error. Unfortunately, it sometime still
generates unstable forecasts. The instability of forecasts still cannot be overcome thoroughly.
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Hence following from the finding of weakness lied in the established adaptive model, James
W. Taylor (2004) has developed a new approach namely Smooth Transition Exponential
smooth transition model (See Terasvirta, 1998). STES adopts the essence of smooth
transition variable. The sign |εt-1| and size εt-1 of past shocks were proposed to be used as
transition variables in STES which have also been used in smooth transition model. In the
empirical studies of James W. Taylor (2004), the reason for the sign of past shocks has been
used as a transition variable is to model the asymmetry in stock return volatility, known as
the “leverage effect”. This asymmetry is characterised by the tendency for negative returns to
be followed by periods of greater volatility than positive returns of equal size. The size of the
past shocks has also been used as a transition variable in order to allow a more flexible
Exponential Smoothing (STES) is the integration of the logistic function of a user specified
variable as adaptive smoothing parameter which analogous to smooth transition with the
In the empirical works of James W. Taylor(2004), the results have not only exhibited the
solution to unstable forecasts, but it also proved that STES has outperformed fixed parameter
major stock markets namely Amsterdam (EOE), Frankfurt (DAX), Hong Kong (Hang Seng),
London (FTSE100), New York (S&P 500), Paris (CAC40), Singapore (Singapore all shares)
and Japan (Nikkei). In view of the excellent performance of STES in stock markets, we
would like to study its performance in commodity markets in this paper. If it excellent
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performance is proven in commodity market too, we then confident to extend its application
Perry Sadorsky 2006 has modelled and forecasted the crude oil volatility by using a five-year
rolling window. The daily ex post variance is measured by squared daily return which is
conformed to approach of Brailsford and Faff, 1996; Brooks and Persand, 2002. Under the
rolling window, the estimation period is rolled forward by adding one new day and dropping
the most distant day. In this way the sample size used in estimating the models stays at a
fixed length and the forecasts do not overlap. Thus there are 2651 one-day volatility forecasts
for each oil future prices, included crude oil, heating oil unleaded gas and natural gas. A
number of univariate and multivariate models are used to model and forecast petroleum
future price volatility. The models applied included random walk, historical mean, moving
average, exponentially smoothing (ES), linear regression model (LS), autoregressive model
(AR), GARCH (1,1), threshold GARCH, GARCH in mean and bivariate GARCH. The out-
of-sample forecasts are evaluated using forecast accuracy tests and market timing tests. No
one model fits the best for each series considered. Most models out perform a random walk
and for most models there is evidence of market timing. The TGARCH model fits well for
heating oil and natural gas volatility and GARCH model fits well for crude oil and unleaded
gasoline volatility. The result of crude oil was conformed to Bollerslev et al (1992), Jui-
Cheng H., Ming-Chih L., Hung-Chun L., (2008). There are some other articles in the energy
literature have using GARCH models and its variants also to addressed the modelling and
forecasting of crude oil market volatility, such as Adrangi et al., 2001, Cabedo and Moya,
2003, Fong and See, 2002; Giot and Laurent, 2003; Morana, 2001; Narayan and Narayan,
2007; Sadeghi and Shavvalpour, 2006; however, there is currently no general consensus on
9
the modelling and forecasting of crude oil volatility, because the standard GARCH models
Day and Lewis studied the predictive power of GARCH (1,1), EGARCH(1,1), implied
volatility and historical volatility for crude oil based on data from November 1986 to March
1991. They estimated the realized volatility on out-of-sample forecast by using OLS
regression, check the unbiasedness of the forecast by referring to coefficient estimates; and
evaluate the relative predictive power with reference to R2 value. For the accuracy of out-of-
sample forecasts is compared using Mean Forecast Error (ME), Mean absolute Error (MAE)
and Root Mean Square Error (RMSE). From the out-of-sample results shown that, GARCH
forecasts and historical volatility do not add much explanatory power to forecast based on
implied volatilities. This would means that each method did not contribute unique
information not contained in the other in the composite forecast by using implied volatility
and GARCH model. They concluded that implied volatility alone is sufficient for market
Duffie and Gray (1995) applied GARCH (1,1), EGARCH(1,1) bi-variate GARCH, regime
switching, implied volatility and historical volatility predictors to compared with the realized
volatility to construct in-sample and out-of-sample forecast volatility in the crude oil, heating,
oil and natural gas markets. The forecast accuracy was evaluated with the criterion of RMSE.
The result shown that, implied volatility yields the best forecasts in both the in-sample and
out-of-sample cases, and in the more relevant out-of-sample case, historical volatility
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The empirical studies of Sang H. Kang, San-Mok Kang and Seong-Min Yoon, 2009 were
focused on investigates the efficacy of a volatility model for 3 crude oil markets – Brent,
Dubai and West Texas Intermediate (WTI). They used CGARCH, FIGARCH, GARCH and
IGARCH to assess persistence in the volatility of the three crude oil prices. They presented
that the estimated value of the persistence coefficient α + β are quite close to unity in the
standard GARCH (1,1) model, a fact that favours the IGARCH (1,1) specification. As the
IGARCH (1,1) model nests the GARCH (1,1) models, the estimates of the IGARCH (1,1)
model are quite similar to those of the GARCH (1,1) model. In the case of CGARCH (1,1)
model, the estimated α + β is smaller than that of the GARCH model, thereby indicating that
the short-run volatility component is weaker. Whereas in the case of FIGARCH (1,d,1) model
describe volatility persistence for the three crude oil returns. Hence, unlike the GARCH and
IGARCH models, the CGARCH and FIGARCH models are able to capture volatility
persistence due to the insignificance of diagnostic tests. Therefore, the CGARCH and
FIGARCH models are able to capture persistence in the volatility of crude oil. As a result,
CGARCH and FIGARCH models generate more accurate out-of-sample volatility forecasts
Chin Wen Cheong (2009) investigated the time-varying volatility of two major crude oil
markets, the West Texas Intermediate (WTI) and Europe Brent. A flexible autoregressive
conditional heteroskedasticity (ARCH) models is used to take into account the stylized
volatility facts such as clustering volatility, asymmetric new impact and long memory
volatility among others. The empirical results indicate that the intensity of long-persistency
volatility in the WTI is greater than in the Brent. It is also found that the WTI, the
appreciation and depreciation shocks of the WTI have similar impact on the resulting
volatility. However, a leverage effect is found in Brent. Although both the estimation and
11
diagnostic evaluations are in favour of an asymmetric long memory ARCH model, only the
WTI models provide superior in the out-of-sample forecasts. On the other hand, from the
ARCH provides the best forecasted evaluations for the Brent crude oil data.
Other than variants GARCH models as forecasting model, Christopher J. Neely, 2003, tested
the predictive power of implied volatility. He conform the consistency of implied volatility as
a biased predictor of realized volatility of gold future to the findings in other markets. There
is no existing explanation – including a price of volatility risk – can completely explain the
bias, but much of this apparent bias can be explained by persistence and estimation error in
implied volatility. Statistical criteria reject the hypothesis that implied volatility is
informational efficient with respect to econometric forecasts. But delta hedging exercise
indicates that such econometric forecasts have no incremental economic value. Thus,
statistical measures of bias and information efficiency are misleading measure of the
On the examination of the literature for gold, it is surprising to report that little research has
been carried out on gold volatility forecasting. Most of the gold studies did not relate to
release on gold and silver prices; Cai et al (2001), undertook an analysis of the effect of 23
reports, GDP, CPI and personal income. Both studies were using gold futures intra-day data;
Edel et al. (2007) investigated macroeconomic influences on gold using the asymmetric
power GARCH model (APGARCH); Lucia Morales (2007), using EGARCH to investigate
the nature of volatility spillover between precious metals returns (included gold, platinum,
12
palladium and silver) over the 1995 – July 2007 period. The results evidence the existence of
volatility persistence and spillovers among four precious metal return during price
fluctuations and strong impact of information on volatility from one market to another market.
Batten and Lucey (2006) analysed the volatility structure of gold, trading as a future contract
on the Chicago Board of Trading using intraday (high frequency) data from January 1999 to
December 2005. They used GARCH modelling and the Garman Klass estimator. They found
significant variations across the trading days consistent with microstructure theories, although
volatility is only slightly positively correlated with volume when measured by tick-count.
In the empirical studies of Ali M. Kuntan and Tansu Aksoy (2004), they employed a lead-lag
model within a GARCH framework, allowing them to better capture observe time-varying
volatility of gold in emerging market, Istanbul Gold Exchange. By using standard GARCH
(1,1) model, gold returns were used to estimate the time varying variance of returns. They
include public information arrival data in both the mean and variance equations. The
statistical tests results (not reported) indicated no significant serial correlation in gold returns.
The result shows that the estimated ARCH and GARCH terms are statistically significant to
the 5 percent significance level or better. The only significant public information variable is
the industrial production with a lead effect. The sign is negative, indicating that the
conditional volatility of returns declines in response to such news. The diagnostic tests
reported suggest that the estimated model does not suffer from any serial correlation up to ten
lags. In addition, the estimated Q-squared tests indicate that the reported GARCH (1,1)
models well capture the observed time-varying volatility behaviour of gold market returns.
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2.4 Previous Studies about the relationship between gold and crude oil
In this section, we are going to review the literature about gold volatility related to crude oil
price. The interest rate model proposed by Brenner, Harjes, Kroner (1996) (BHK hereafter) is
applied here to investigate gold volatility. Besides that, GARCH models have become
common tools for the time series heteroskedastic models; however, the data transformation
involved the use of a squared term. Ding, Granger, and Engle (1993) suggested a new class of
GARCH models, called the power GARCH (PGARCH) model, where the power term is
flexible rather than fixed arbitrarily. The PGARCH structure is flexible enough to nest both
the conditional variance (Bollerslev, 1986) and the conditional standard deviation (Taylor,
1986) models as particular cases. In the empirical results of Cheng, Su and Tzou (2009)
shown that, the effects of crude oil volatility on gold return and volatility are emphasized by
observing the coefficient φ1 to φ4. Most of them are significantly negative and it means that
the crude oil volatility is negative relative to either gold return or volatility. The higher the
crude oil volatility, the lower the gold return and volatility. They find that only the jump
volatility of crude oil exhibits a negative relationship to the gold return, while the GARCH
volatility of the crude oil does not. However, as to the gold volatility and both crude oil
In the empirical study of Melvin and Sultan 1990, the shown that the political unrest and oil
price changes in South African are significant determinants of the conditional variance of
spot price forecasts errors (volatility) of gold futures. They applied ARCH-in-Mean models
to estimate the forecast errors of gold futures. The empirical results shown that, the term
is significant and positive in the spot price equation. The coefficient of the ARCH
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2.5 Realized Volatility
In recent year, with the availability of high-frequency financial market data modelling
realized volatility has become a new and innovative research direction. The construction of
“observable” or realized volatility series from intra-day transaction data and the used o
standard time-series technique has lead to promising strategies for modelling and predicting
daily volatility. The use of high-frequency data has induced dramatic improvements in both
measuring and forecasting volatility. Andersen and Bollerslev (1998) firstly introduced
frequency intraday square returns. Forecasts from long memory models provide notable
improvements over daily GARCH forecasts at the 1- day and 10-day horizons. The modelling
of the long memory property in volatility has the potential to improve forecasts particulars for
much longer horizons, needed to compete with option implied volatility forecasts. The results
for crude oil in this studies show that long memory forecasts dramatically improve upon daily
GARCH forecasts, confirming the results of Andersen et al. for exchange rates.
David and Alan (2004) applied the cumulative squared returns from intra-day data to
supersede ex post daily squared returns as the measure of the “true volatility” in the
forecasting of exchange rate for 17 currencies relative to the US dollar over the period 1
January 1990 to 31 December 1996. The result indicates that the GARCH model outperforms
smoothing and moving average techniques which have been previously identified as
Fulvio et al. (2008) shown that the residuals of commonly used time-series models for
realized volatility and logarithmic realized variance exhibit non-Gaussianity and volatility
clustering. He extend the explicitly account for these properties and assess their relevance for
15
modelling and forecasting realized volatility. In the empirical application for S&P 500 index
futures, the results shown that the realized volatility model which allowing for time-varying
2.6 SUMMARY
We noticed from the literature review, there is very limited volatility forecasting method had
been applied in commodity market except variants of GARCH models. STES model has
proven never been used in commodity market except in equity market by Taylor, 2004. We
proposed to apply STES approaches for return volatility forecasting of crude oil and gold
The daily spot crude oil price (US dollars per barrel) and spot gold prices (US dollar per kg)
prices over the period from August 1995 to July 2009 with 3655 daily observations. In this
paper, the daily data have been converted into observed weekly data with 731 weekly
observations. 531 out of 731 observations were used to evaluate in-of-sample volatility
forecasts, and the balance for out-of-sample evaluation. The closing prices on each
The spot prices of crude oil have been profoundly influenced by event that has great impacts
to global economic. i.e. surged of crude oil price to $145 per barrel in July 2008;
16
Following Kanas (2000), the continuously compounded returns were used. We calculate the
Where Ri,t is the return for i( meant to crude oil and gold ) at time t, Pi,t is the current weekly
price, and Pi,t-1 are the previous week’s price. In accordance to with the study of Sadorsky
estimation methodology of GARCH family is using the maximum likelihood method which
allows the log returns and variance process to be estimated simultaneously. The estimation of
regression parameters µ for estimated errors εt started from log return (lnret) of each series by
using OLS estimates. The errors terms εt will then be squared for GARCH measurement as
3.2 Methodology
3.2.1 General
According to James W. Taylor (2004), even though many authors use volatility-based cost
Jorion, 1995; Xu & Taylor, 1995), the use of a volatility-based cost function to estimated
parameters is rare. The reason for this is that there is no simple proxy for actual volatility. In
the work on evaluating variance forecasts of Andersen and Bollerslev (1998), he shown that
higher frequency data can be used to construct realised variance, which is a better proxy for
daily data to calculate realized weekly variance in order to evaluate variance forecasts for
weekly data. In our case here, we propose the use of higher frequency data i.e., daily squared
17
error
to calculate weekly realized variance for use. The proposal amount to the parameters
Min Σ|
-
| (2)
Where is realized variance at period i calculated from the higher frequency data. We
calculated the realized weekly variance from the observation for the 5 trading days in the
=
(3)
- Difference between squared errors and forecasted variance with formula shown below:
Σ (
-
) (4)
Σ|
-
| (5)
Besides weekly forecasted volatility, the forecast for the volatility over a 5-day hold period
would then serve as a forecast for weekly volatility also. We have DAILY-GARCH, DAILY-
When additional variance regressor or transition variable has been added to GARCH and
STES respectively, the parameters are estimated with Maximum Likelihood method in
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GARCH models and optimize the parameters by minimizing the sum of squared in-sample
(1,1) specification, model of Bollerslev (1986). The conditional Student’s t density which
originally was suggested by Bollerslve (1987) and is useful for dealing with excess kurtosis is
applying in this study. Under the Student’s distribution, the log-likelihood contributions are
of the form:
%
!("
)#$ '( (* ) (,-.θ)()
t =
log &
#((" ))
)(
- log
-
log (1 +
/0& (*
)
(6)
Where the degree of freedom v>2 controls the tail behavior. The t-distribution approaches the
normal as v→∞.
Now, let look at the methodology used in each forecast models in next section.
defined as a logistic function of a user-specified transition variable, Vt. The logistic function
yt = a +btxt +et,
2
where b= 345 (678) (7)
function of Vt, depends on γ<0 and ω>0 and vice versa. Vt will varies between 0 and ω to
19
model logistic function of a user specified variables. This logistic function model is then
ft+1=αt yt + (1 - αt) ft ,
2
αt= 345 (678) (8)
Where αt = (9)
9:; (β γ8)
If γ < 0, αt is a monotonically increasing function of Vt. Hence, as Vt increases, the weight on yt rises,
and correspondingly the weight on ft decreases. The logistic function restricts αt to lie between 0 and
1. Although a wider range can be justified (Gardner, 1985). Vt become a monotonically increasing
function if γ <0. The weight on yt rises as Vt increase and relatively the weight on ft decreases.
The logistic function restrict αt lie between 0 and 1. Under this approach, the historical data is
used to calibrate the adaptive smoothing parameter, αt through the estimation of β and γ in
(13), (James W.T., 2004). In short, Smooth Transition Exponential Smoothing (STES) is the
integration of smooth transition with exponential smoothing where the logistic function in smooth
There are 5 STES models have been introduced in this empirical work. The new model has
never been used in forecasting the volatility of any commodity products. This is the first time
it has been used for commodity product. The STES models using 5 different transition
variables: εt-1 (STES-E); |εt-1| (STES-AE); (STES-SE); εt-1 and |εt-1| together (STES-
E&AE); εt-1 and together (STES-ESE). We optimised the STES parameters using the
20
Min Σ|
-
| (10)
When an additional transition variable of gold will added to the crude oil formulation to
examine does gold return significantly impact on return volatility of crude oil. The
Where αt,oil= (11)
9:; (β,>
?γ8,>
?)
αt ,oil is the adaptive smoothing parameters. βoil and γoil are coefficient of crude oil. Vt, oil is
the transition variables of crude oil. When additional transition variable of gold is added to
αt,oil= 9:; (β,>
?γ8,>
? @,A>?B) (12)
Under the 5 modified formulations, the transition variables of crude oil εt,oil-1 (STES-E); |εt,oil-
1| (STES-AE); ,> ?
together (STES-ESE). Gold as additional transition variable will be added on to crude oil
εt,gold-1 in (STES-E);
|εt,gold-1| in (STES-AE);
,A>?B in (STES-SE);
,A>?B in (STES-ESE)
21
3.2.3 GARCH Models
Bollerslev et al. (1992) showed that the GARCH(1,1) specification works well in most
applied situations, and Sadorsky (2006) also indicated that the GARCH(1,1) model fits well
The conditional mean and variance equations of GARCH-N model can be written as follows:
= ω + α +β (14)
Where rt denotes the rate of return, and ω, α and β are non negative parameters with the
In the empirical works of Claire Lunieski, (2009), GARCH is the better forecasting model to
explain the causes of volatility of commodity. This is because most of the commodity data
contains heteroskedastic errors resulting from varying risks associated with differing time
periods. Thus, “the expected value of the magnitude of error terms at some times is greater
than at other” (Engle 2001). Hence, GARCH models able to estimate the causal factors in
volatility by analyzing the heteroskedastic error term. Heteroskedasticity has been defined as
“the variance on the error term is not consistent over time.” The formula of GARCH is shown
= D + E 1 +F 1 (15)
GARCH models express the conditional variance as a linear function of lagged squared error
terms and also lagged conditional variance term (James W. Taylor 2004). The parameters of
immediate past variance , as a result the variance is changing over time (ie
heteroskedasticity).
22
Therefore, the GARCH model has emerged as a primary tool to estimate commodity price
volatility. Hammoundeh and Yuan (2008) employ multiple variations of the GARCH model
in the presence of positive interest rate shocks and changes in short term interest rates” (609).
By using the GARCH and EGARCH, Hammoundeh and Yuan able to analyzed the impact of
past shocks, the effects of “good and bad news” on volatility and the effect of transitory and
persistent volatility in the short and long runs (Claire Lunieski 2009). He finds that the future
volatility can be predicted by past shocks and volatility. Especially past volatility provide
more strength to prediction of future volatility. Batten and Lucey (2006) used GARCH and
Garman Klass estimator to analyse the volatility of gold, they found out the volatility is only
3.2.3.1.1 Regressor
We would like to investigate the effect of gold return on the return volatility of crude oil and
.
vice versa. Hence we consider the use of the lagged residual return of gold, G ,A>?B as an
element in the variance equation of GARCH models. The GARCH(1,1) model, presented in
H
5
.
,>
? = D + Fj ,>
? +
Ei ,>
? + G ,A>?B I (16)
where w > 0, and α 1 , β1 , λ ≥ 0 . We term this model GARCH-Gold. Under this approach,
the standard GARCH (1,1) is extended to allow for the inclusion of exogenous or
predetermined regressors, z. In this case, ,> ? is the conditional variance of crude oil.
.
G,A>?B I is the additional regressor, which is εt,gold-1 of gold added into the crude oil
variance equation with purpose to examine how significant of gold price impact to the
23
volatility of crude oil. If the probability shown that it is less than 0.05 with 5% significant
testing, then gold price significant to volatility of crude oil price and otherwise.
3.2.3.2 IGARCH
Integrated GARCH (IGARCH) a model was originally developed by Engle and Bollerslev
(1986). The parameters under this model have been restricted to sum of one and drop the
= βJ +
K1 (17)
Such that
H βJ + 5 α1 = 1 (18)
The modified formulation of IGARCH with inclusion of gold as additional variance regressor
is shown below:
+ 5
K1,>
?
+ G,A>?B I (19)
GARCH has been generalized in Ding et al(1993) with the Power specification. In this model,
the power parameter δ of the standard deviation can be estimated rather than imposed and the
optional γ parameters are added to capture asymmetry of up to order r. The advantage is that
“rather than imposing a structure on the data, the PARCH model allows a power
transformation term inclusive of any positive value and so permits a virtually infinite range of
transformations” (McKenzie et al. 2001). The power term is the means by which the data are
transformed. The power term captures volatility clustering by changing the influence of the
outliers. McKenzie and Mitchell (1999) highlights that volatility clustering is not just specific
to the use of squared asset returns but are also a component of absolute returns. The use of a
24
power term in these cases acts to emphasis the periods of tranquillity and volatility by
amplifying the outliers in the data set. The PARCH formulation is described as below:
H 5
δ = ω + βJ
δ
+
αi(|εt-1| - γiεt-1)δ (20)
Where δ >0, |γi| ≤1 for i=1,…..r, γI = 0 for all i>r, and r≤p.
The symmetric model sets γi =0 for all i. Note that if δ =2 and γi =0 for all i, PARCH model is
The modified formulation of PARCH with inclusion of gold as additional variance regressor
is shown below:
.
,>
?
δ
= ω + H βJ ,>
?
δ
+ 5
αi(|εt,oil-1| - γiεt,oil-1)δ + G,A>?B I (21)
3.2.3.4 EGARCH
The EGARCH model was developed by Nelson(1991). The model explicitly allows for
asymmetries in the relationship between return and volatility, which assumes the asymmetric
between positive and negative shocks on conditional volatility. The EGARCH(1,1) model is
expressed as follow:
Log (σ
) = ω +α (| | - Ε(|εt-1|)) + γεt-1 + βlog( ) (22)
| | and εt-1 in the equation above meant to capture the size and sign effects of the
standardized shocks respectively. Exponential GARCH (EGARCH) has been used to test for
the presence of the leverage effect as per asymmetric GARCH. When the expected value of
γ<0, the positive shocks provide less volatility than the negative shocks. The asymmetric and
leverage effect has happened. Adrangi et al (2001b) has used it to show that conditional
heteroskedasticity is the source of non-linearities in energy price data. In his study of crude
oil, heating oil, and unleaded gasoline futures Adrangi et al. (2001b) find that the crude oil
25
L L
Log(ht) = α0 + α1 + α2 | Q + β1log(ht-1) + β2TTM (23)
MNOP1 MNOP1
Where ht is the conditional variance, εt is the interruption term, and TTM is the time to
maturity. The maturity effect is important for testing. The volatility tended to increase while
the delivery date is approached. The negative and significant parameter estimation of α2 has
proven the existence of leverage effect. Lucia (2007) used EGARCH model to evidence the
existence of volatility persistence and spillovers among four precious metal return (gold,
palladium, platinum and silver) during price fluctuations and strong impact of information on
volatility from one market to another market. This is influential impact is particularly obvious
in gold market.
Log (σ
,>
? ) = ω +α (| ,>
? | - Ε(|εt,oil-1|)) + γεt,oil-1 + βlog(,>
? ) + G,A>?B I (24)
In the empirical work of Duong T.Le (2006), he was using GJR (TGARCH) model to
examine the differential impacts on the conditional variance between positive and negative
shocks of equal magnitude in the crude oil and natural gas market. The estimated mean and
Rt = µ + Φ1Rt-1 + εt (25)
where εt is a normally distributed random variable with conditional mean zero and
conditional variance ht; It-1=1 if εt-1<0 and 0 otherwise. The asymmetric impact is allowing by
the impact of positive and negative shocks on conditional variance. Asymmetric volatility
26
implies γ ≠0 in equation (8). γ>0 implies that conditional volatility was increased more by the
regressor is as follow:
.
ht,oil = ω +α ,>
? + βht,oil-1 + γ ,>
? It,oil-1 + G,A>?B I (27)
The results for 530 in-sample estimations of Crude oil and Gold price for variants GARCH
models are shown in table 2 & 3 below respectively. The tables reported the relevant
parameter estimates for the variant GARCH models. The diagnostic tools are Akaike
Information Criterion (AIC) and Log Likelihood (lnL). AIC is a measure of the goodness-of-
fit of an estimated statistical model. It is grounded in the concept of entropy, in effect offering
a relative measure of the information lost when a given model is used to describe reality and
can be said to describe the trade off between bias and variance in model construction, or
loosely speaking that a accuracy and complexity of the model. The AIC is not a test of the
model in the sense of hypothesis testing; rather it is a test between models – a tool for model
selection. Given a data set, several competing models may be ranked according to their AIC,
with the one having the lowest AIC being the best.
As seen from the tables, the parameters α and β in GARCH (1, 1) models are significant at
the 5% level in gold; whereas in the case of crude oil, α shown insignificant but β significant
at 5% level. The constant variance model will be rejected as a consequent in gold. We also
27
noticed that, the sum values of α and β parameters are closed to unity for both cases under
The parameters estimation for TARCH (GJR), IGARCH, EGARCH and PARCH are shown
below. In TARCH (GJR), if α>γ would indicates the present of the leverage effect. But the
parameter shown otherwise in both case, which indicates that if fail to capture leverage effect.
EGARCH, when the expected value of γ<0, the positive shocks provide less volatility than
the negative shocks. The asymmetric and leverage effect has happened. But the parameter
shown below indicates that leverage effect did not happen for both cases. We report
parameter estimates δ in the PARCH model. The estimation of γ & δ parameters in these
models indicates that they are always relevance in estimation. The symmetric model sets γi
=0 for all i. If δ =2 and γi =0 for all i, PARCH model is simply a standard GARCH
specification. But the parameter shown below indicates otherwise in both cases.
The values of lnL seems has confirmed the usefulness of non-linear modifications to the
linear GARCH models, even though AIC value fail to spell it clear with the negative value
for both series. From the AIC value, TARCH exhibit the lowest value which indicates it is the
best performers among all variants of GARCH for crude oil and GARCH (1,1) shown to be
28
Table1: Estimation results of variant GARCH models for Crude oil
29
4.2 Out-Sample Forecasting results
200 observations of out-sample forecasting results are shown in tables from 4 to 7 below. The
out-sample estimations for STES models were illustrated by theil-u below. The value bolded
in red under column namely “Theil-U” indicates the best performing methods for both
commodity products. The measurement of Theil-U for each models is derived by divided the
RMSE value of each model by the lowest RMSE value among all the models. The lowest
value of Theil-U the best model it is. The weekly volatility was forecasted by using
and
realized volatility as a proxy of actual variance respectively. The parameters were estimated by
minimizing the sum of squared deviations between estimated or realized and forecast
variance. The size and sign of past shocks have been used as transition variables. Root mean
square error (RMSE) was used as evaluation tools as shown in table 4, 5, 6 and 7 below. The
RMSE = √
RR
RR
)
(
-
2
(28)
In table 4, Daily -STES-E+AbsE without regressor ranked top for gold series. This is
conformed to Andersen and Bollerslev results that high-frequency data provide more accurate
return volatility forecasting. In overall, GARCH models or STES approaches are performed
pretty well with high-frequency data for both without and with regressor & additional
transition variable. However, this concept did not apply in crude oil where the return
volatility forecasts shown slightly better than weekly forecasts. The best performance of
indicates that crude oil return has insignificant impact to the prediction of return volatility in
gold. In another word, existence of crude oil return did not explain the return volatility of
gold. In the crude oil series, the weekly STES-E+AbsE in categories with regressor and
additional transition variable outperformed all other methods. This result indicates that gold
30
return has impact to the return volatility of crude oil. It is an unexpected result, which also
means that, gold return help in improving the return volatility of crude oil. gold return can
explain the return volatility of crude oil. In overall, Daily- STES-E+AbsE under category
without regressor outperformed all other models as proven by lowest value of mean Theil-U
scored at 11.
Table 3: RMSE for 200 out-of-sample volatility forecasts using SUT as actual variance
MEAN
Without regressor or additional
Methods THEIL
transition variable
-U
GOLD PRICE CRUDE OIL
RMS THEIL RANKIN RMS THEIL RANKIN
E -U G E -U G
Ad hoc methods - weekly
STES-SE 246 1.451 27 600 1.068 10 18.5
STES-E 249 1.472 38 602 1.071 11 24.5
STES-AbsE 245 1.449 24 603 1.072 12 18
STES-E+AbsE 245 1.449 23 584 1.038 4 13.5
STES-ESE 245 1.450 26 582 1.035 3 14.5
Ad hoc methods - daily
DAILY-STES-SE 177 1.048 9 687 1.221 26 17.5
DAILY-STES-E 184 1.088 15 736 1.309 38 26.5
DAILY-STES-
174 1.027 3 701 1.246 32 17.5
AbsE
DAILY-STES-
169 1.000 1 679 1.207 21 11
E+AbsE
DAILY-STES-
173 1.024 2 684 1.215 24 13
ESE
GARCH models - Weekly
GJR 247 1.461 33 685 1.217 25 29
GARCH 247 1.461 35 637 1.133 18 26.5
IGARCH 248 1.464 36 591 1.052 8 22
PARCH 246 1.456 29 626 1.112 14 21.5
EGARCH 246 1.451 28 633 1.126 17 22.5
GARCH models - Daily
DAILYGJR 188 1.113 18 700 1.245 31 24.5
DAILY-GARCH 189 1.117 20 696 1.238 29 24.5
DAILY-IGARCH 181 1.069 12 735 1.306 36 24
DAILY-PARCH 183 1.084 14 690 1.226 27 20.5
DAILY-EGARCH 174 1.031 6 678 1.205 20 13
With regressor or additional transition variable
GOLD PRICE (GP)- CO CRUDE OIL (CO) - GP MEAN
OUT-OF-
(REGR) (REGR) THEIL
SAMPLE
RMS RMS -U
E Theil-U Ranking E Theil-U Ranking
31
Ad hoc methods - weekly
STES-SE 245 1.446 21 612 1.088 13 17
STES-E 257 1.516 40 644 1.145 19 29.5
STES-AbsE 253 1.496 39 587 1.043 6 22.5
STES-E+AbsE 245 1.448 22 562 1.000 1 11.5
STES-ESE 249 1.468 37 584 1.039 5 21
Ad hoc methods - daily
DAILY-STES-SE 179 1.058 10 712 1.266 35 22.5
DAILY-STES-E 188 1.112 16 735 1.307 37 26.5
DAILY-STES-
1.044 8 1.418 40 24
AbsE 177 798
DAILY-STES-
1.027 4 1.257 34 19
E+AbsE 174 707
DAILY-STES-
1.037 7 1.209 23 15
ESE 176 680
GARCH models - Weekly
GJR 247 1.458 32 582 1.034 2 17
GARCH 247 1.458 31 596 1.060 9 20
IGARCH 247 1.461 34 590 1.048 7 20.5
PARCH 247 1.457 30 626 1.113 16 23
EGARCH 245 1.450 25 626 1.112 15 20
GARCH models - Daily
DAILYGJR 188 1.112 17 705 1.254 33 25
DAILY-GARCH 189 1.115 19 700 1.244 30 24.5
DAILY-IGARCH 181 1.068 11 737 1.310 39 25
DAILY-PARCH 183 1.081 13 694 1.234 28 20.5
DAILY-EGARCH 174 1.028 5 680 1.208 22 13.5
As shown in Table 4, weekly RV-AR ranked at top for Gold series when there is no regressor or
additional transition variable. This results it conformed to James empirical results found in 2004
tested for 8 stocks markets. STES-E-AbsE outperformed other methods in Crude oil series. We notice
that, the high-frequency data provided better return volatility forecast for both series in both
categories of without and with regressor. We also found out that, both best performers fall under
category without regressor or additional transition variable. This result indicated that, the return of
other commodity product has no impact to the return volatility of either crude oil or gold when RV
was used as a proxy of actual variance. In overall, all daily STES approaches scored lowest mean
32
Table 4: RMSE for 200 out-sample volatility forecasts using RV as actual variance
Without regressor or additional transition variable
GOLD PRICE CRUDE OIL MEAN
RMS THEIL- RANKI RMS THEIL- RANKI THEIL-U
E U NG E U NG
Ad hoc methods - weekly
STES-SE 125 3.020 21 546 2.904 35 28
STES-E 129 3.112 29 554 2.945 36 32.5
STES-AbsE 127 3.071 25 464 2.471 26 25.5
STES-E+AbsE 147 3.548 42 615 3.272 40 41
STES-ESE 125 3.022 22 452 2.403 22 22
Ad hoc methods - daily
DAILY-STES-
112 2.704 9 189 1.007 2 5.5
SE
DAILY-STES-E 116 2.801 14 189 1.007 8 11
DAILY-STES-
115 2.776 12 188 1.000 1 6.5
AbsE
DAILY-STES-
126 3.042 23 191 1.018 10 16.5
E+AbsE
DAILY-STES-
122 2.945 20 189 1.007 8 14
ESE
GARCH models - Weekly
GJR 128 3.096 27 683 3.634 41 34
GARCH 129 3.118 31 529 2.815 32 31.5
IGARCH 130 3.142 34 536 2.850 34 34
PARCH 133 3.203 38 498 2.650 29 33.5
EGARCH 132 3.197 37 563 2.994 37 37
GARCH models - Daily
DAILYGJR 121 2.919 18 431 2.291 17 17.5
DAILY-
121 2.920 19 431 2.293 18 18.5
GARCH
DAILY-
135 3.255 41 418 2.222 13 27
IGARCH
DAILY-
112 2.697 8 423 2.247 16 12
PARCH
DAILY-
116 2.804 15 455 2.420 24 19.5
EGARCH
RV-AR method - Weekly
RV-AR 41 1.000 1 506 2.690 31 16
With regressor or additional transition variable
OUT-OF- GOLD PRICE (GP) - CO CRUDE OIL (CO) - GP MEAN
SAMPLE (REGR) (REGR) THEIL-U
Rankin
MAE Theil-U Ranking MAE Theil-U
g
Ad hoc methods - weekly
STES-SE 126.97 3.066 24 392.01 2.085 12 18
33
STES-E 131.67 3.179 35 475.72 2.530 28 31.5
STES-AbsE 129.15 3.118 32 456.83 2.430 25 28.5
STES-E+AbsE 131.75 3.181 36 467.64 2.487 27 31.5
STES-ESE 128.30 3.098 28 452.05 2.405 23 25.5
Ad hoc methods - daily
DAILY-STES-
79.11 1.910 3 189.38 1.007 3 3
SE
DAILY-STES-E 79.11 1.910 3 189.38 1.007 3 3
DAILY-STES-
79.11 1.910 3 189.38 1.007 3 3
AbsE
DAILY-STES-
79.11 1.910 3 189.38 1.007 3 3
E+AbsE
DAILY-STES-
79.11 1.910 3 189.38 1.007 3 3
ESE
GARCH models - Weekly
GJR 128.09 3.092 26 690.42 3.672 42 34
GARCH 129.03 3.115 30 593.39 3.156 39 34.5
IGARCH 129.84 3.135 33 530.35 2.821 33 33
PARCH 132.85 3.207 39 505.47 2.689 30 34.5
EGARCH 133.36 3.220 40 575.57 3.062 38 39
GARCH models - Daily
DAILYGJR 117.54 2.838 16 434.06 2.309 20 18
DAILY-
112.08 2.706 10 433.38 2.305 19 14.5
GARCH
DAILY-
112.76 2.722 11 421.37 2.241 15 13
IGARCH
DAILY-
115.63 2.792 13 420.45 2.236 14 13.5
PARCH
DAILY-
118.83 2.869 17 448.11 2.384 21 19
EGARCH
RV-AR Method
RV-AR 42.08 1.016 2 326.69 1.738 11 6.5
34
CHAPTER 5 CONCLUSION AND IMPLICATION
In this paper, we had testing the accuracy of volatility forecasting of 5 types STES models in
commodity market. The transition variables , εt-1 and |εt-1| were used to replicate the
conditional variance dynamics of the smooth transition GARCH models. The outperformance
of STES revealed that the specific characteristics such as seasonality volatility and inverse
leverage effect found in commodity markets have been captured and adjusted well into STES
models. The predictive power of STES has been proven stronger than the popular models
such as GARCH. The overall results revealed that, STES models performed very well in the
With this encouraging result, it proven that, STES has accurately forecast the volatility not
only in financial market, but also performed very well in commodity markets. It implies that,
STES might work well in most applied situations as long as there are specified transition
The lower RMSE value shown in Daily-GARCH and Daily-STES while applied realized
variance as a proxy to actual variance indicated that high frequency data provide better return
volatility forecasts as compared to squared errors terms as actual variance. This would means
Whereas, the results for models without regressor or additional transition variable shown that,
the return of other commodity product has no impact to the return volatility forecasting for
either crude oil or gold in both RV and squared error was used as proxy of actual variance.
Nevertheless, only gold return has significant impact to return volatility of crude oil when
squared error was used as actual variance. The limitation of this research is that only 2
35
commodities were studied which would not reflect the whole picture of full commodity
markets. Hence, wider range of commodity products should be explore when study STES in
36
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