Journal of International Money and Finance 42 (2014) 9–37

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Journal of International Money

and Finance
journal homepage: [Link]/locate/jimf

Risk premia in crude oil futures pricesq

James D. Hamilton a, *, Jing Cynthia Wu b
a
Department of Economics, University of California, San Diego, United States
b
Booth School of Business, University of Chicago, United States

a b s t r a c t

Keywords: If commercial producers or financial investors use futures con-

Oil prices tracts to hedge against commodity price risk, the arbitrageurs who
Speculation take the other side of the contracts may receive compensation for
Futures risk premium
their assumption of nondiversifiable risk in the form of positive
Affine term structure models
expected returns from their positions. We show that this interac-
tion can produce an affine factor structure to commodity futures
prices, and develop new algorithms for estimation of such models
using unbalanced data sets in which the duration of observed
contracts changes with each observation. We document significant
changes in oil futures risk premia since 2005, with the compen-
sation to the long position smaller on average in more recent data.
This observation is consistent with the claim that index-fund
investing has become more important relative to commerical
hedging in determining the structure of crude oil futures risk
premia over time.

2013 Elsevier Ltd. All rights reserved.

q Financial Support from the University of Chicago Booth School of Business is gratefully acknowledged. We thank Christiane
Baumeister, Rob Engle, Lutz Kilian and anonymous reviewers for helpful comments on earlier drafts of this paper, as well as
participants in the International Conference on Understanding International Commodity Price Fluctuations and seminar par-
ticipants at the Bank of Canada, New York University, Econometric Society Annual Meeting at San Diego, Energy Policy Institute
at Chicago workshop, Applied Time Series Econometrics Workshop at Federal Reserve Bank of St. Louis, Econometric Society
North American Summer Meeting at Chicago, SNDE 21st Annual Symposium at Milan, Econometric Society Australasian
Meeting at Melbourne, and Peking University Guanghua.

* Corresponding author.
E-mail addresses: jhamilton@[Link] (J.D. Hamilton), [Link]@[Link] (J.C. Wu).

0261-5606/$ – see front matter
2013 Elsevier Ltd. All rights reserved.
[Link]
10 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

1. Introduction

Volatile oil prices have been drawing a lot of attention in recent years, with Hamilton (2009) for
example suggesting that the oil price spike was a contributing factor in the recession of 2007–2009.
There has been considerable interest in whether there is any connection between this volatility and the
flow of dollars into commodity-index funds that take the long position in crude oil futures contracts.
Recent empirical investigations of a possible link include Kilian and Murphy (2013), Tang and Xiong
(2012), Buyuksahin and Robe (2011), Alquist and Gervais (2011), Mou (2010), Singleton (2011), Irwin
and Sanders (2012), and Fattouh et al. (2013).
A separate question is the theoretical mechanism by which such an effect could arise in the first
place. Keynes (1930) theory of normal backwardation proposed that if producers of the physical
commodity want to hedge their price risk by selling futures contracts, then the arbitrageurs who take
the other side of the contract may be compensated for assuming that risk in the form of a futures price
below the expected future spot price. Empirical support for this view has come from Carter et al. (1983),
Chang (1985), and De Roon et al. (2000), who interpreted the compensation as arising from the
nondiversifiable component of commodity price risk, and from Bessembinder (1992), Etula (2013) and
Acharya et al. (2013), who attributed the effect to capital limitations of potential arbitrageurs. In the
modern era, buying pressure from commodity-index funds could exert a similar effect in the opposite
direction, shifting the receipt of the risk premium from the long side to the short side of the contract.
In this paper we show that if arbitrageurs care about the mean and variance of their futures
portfolio, then hedging pressure from commodity producers or index-fund investors can give rise to an
affine factor structure to commodity futures prices. We do so by extending the models in Vayanos and
Vila (2009) and Hamilton and Wu (2012a), which were originally used to describe how bond supplies
affect relative yields, but are adapted in the current context to summarize how hedging demand would
influence commodity futures prices. The result turns out to provide a motivation for specifications
similar to the class of Gaussian affine term structure models originally developed by Vasicek (1977),
Duffie and Kan (1996), Dai and Singleton (2002), Duffee (2002), and Ang and Piazzesi (2003) to
characterize the relation between yields on bonds of different maturities. Related affine models have
also been used to describe commodity futures prices by Schwartz (1997), Schwartz and Smith (2000),
and Casassus and Collin-Dufresne (2006), among others.
In addition, this paper offers a number of methodological advances for use of this class of models to
study commodity futures prices. First, we develop the basic relations directly for discrete-time ob-
servations, extending the contributions of Ang and Piazzesi (2003) to the setting of commodity futures
prices. This allows a much more transparent mapping between model parameters and properties of
observable OLS regressions. Second, we show how parameter estimates can be obtained directly from
unbalanced data in which the remaining duration of observed contracts changes with each new
observation, developing an alternative to the Kalman filter methodology used for this purpose by
Cortazar and Naranjo (2006). Third, we show how the estimation method of Hamilton and Wu (2012b)
provides diagnostic tools to reveal exactly where the model succeeds and where it fails to match the
observed data.
We apply these methods to prices of crude oil futures contracts over 1990–2011. We document
significant changes in risk premia in 2005 as the volume of futures trading began to grow significantly.
While traders taking the long position in near contracts earned a positive return on average prior to
2005, that premium decreased substantially after 2005, becoming negative when the slope of the
futures curve was high. This observation is consistent with the claim that historically commercial
producers paid a premium to arbitrageurs for the privilege of hedging price risk, but in more recent
periods financial investors have become natural counterparties for commercial hedgers. We also un-
cover seasonal variation of risk premia over the month, with changes as the nearest contract ap-
proaches expiry that cannot be explained from a shortening duration alone.
The plan of the paper is as follows. Section 2 develops the model, and Section 3 describes our
approach to empirical estimation of parameters. Section 4 presents results for our baseline specifi-
cation, while Section 5 presents results for a model allowing for more general variation as contracts
near expiration. Conclusions are offered in Section 6.
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 11

2. Model

2.1. Role of arbitrageurs

Consider the incentives for a rational investor to become the counterparty to a commercial hedger or
mechanical index-fund trader. We will refer to this rational investor as an arbitrageur, so named because
the arbitrageur’s participation guarantees that risk is priced consistently across all assets and futures
contracts in equilibrium. Let Fnt denote the price of oil associated with an n-period futures contract
entered into at date t. Let znt denote the arbitrageur’s notional exposure (with znt > 0 denoting a long
position and znt < 0 for short), so that znt =Fnt is the number of barrels purchased with n-period con-
tracts. Following Duffie (1992, p. 39), we interpret a long position entered into at date t and closed at
date t þ 1 as associated with a cash flow of zero at date t and Fn1;tþ1  Fnt at date t þ 1. The arbitrageur’s
cash flow for period t þ 1 associated with the contemplated position znt is then znt ðFnt;tþ1  Fnt Þ=Fnt :
We assume the arbitrageur also takes positions qjt in a set of other assets j ¼ 0; 1:::; J with gross returns
between t and t þ 1 denoted expðrj;tþ1 Þ (so that the net return is approximately rj;tþ1 ) and where r0;tþ1 is
assumed to be a risk-free yield. Then the arbitrageur’s total wealth at t þ 1 will be

X
J
  X N
Fn1;tþ1  Fnt
Wtþ1 ¼ qjt exp rj;tþ1 þ znt : (1)
j¼0 n¼1
Fnt

The arbitrageur is assumed to choose fq0t ; .; qJt ; z1t ; .; znt g so as to maximize1

Et ðWtþ1 Þ  ðg=2ÞVart ðWtþ1 Þ (2)

PJ
subject to j¼0 qjt ¼ Wt :
We posit the existence of a vector of factors xt that jointly determine all returns, which we assume
follows a Gaussian vector autoregression (VAR)2:

xtþ1 ¼ c þ rxt þ Sutþ1 ut wi:i:d: Nð0; Im Þ: (3)

Log commodity prices and returns are assumed to be affine functions of these factors
0
fnt ¼ log Fnt ¼ an þ bn xt n ¼ 1; .; N ð4Þ

rjt ¼ xj þ j0j xt j ¼ 1; .; J:

Using a similar approximation to that in Hamilton and Wu (2012a), we show in Appendix A that under
these assumptions,

  XJ h i
Et ðWtþ1 Þz q0t 1 þ r0;tþ1 þ qjt 1 þ xj þ j0j ðc þ rxt Þ þ ð1=2Þj0j SS0 jj
j¼1
(5)
X
N  0 0 0 
þ znt an1 þ bn1 ðc þ rxt Þ  an  bn xt þ ð1=2Þbn1 SS0 bn1
n¼1

0 1 0 1
X
J X
N
0
X
J X
N
Vart ðWtþ1 Þz@ qjt j0j þ znt bn1 ASS0 @ qjt jj þ z[t b[1 A: (6)
j¼1 n¼1 j¼1 [¼1

1
It is trivial to extend this to adding positions in futures contracts for a number of alternative commodities. We discuss here
the case of the single commodity oil for notational simplicity.
2
The assumption of Gaussian homoskedastic errors greatly simplifies the estimation because it implies that parameters of
the reduced-form representation of the model can be optimally estimated using simple OLS. For an extension of this approach
to the case of non-Gaussian factors with time-varying variances, see Creal and Wu (2013).
12 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

The first-order conditions for the arbitrageur’s positions satisfy

vEt ðWtþ1 Þ vVart ðWtþ1 Þ

¼ 1 þ r0;tþ1 þ ðg=2Þ j ¼ 1; .; J
vqjt vqjt
vEt ðWtþ1 Þ vVart ðWtþ1 Þ
¼ ðg=2Þ n ¼ 1; .; N:
vznt vznt

Under (5) and (6) these become

xj þ j0j ðc þ rxt Þ þ ð1=2Þj0j SS0 jj ¼ r0;tþ1 þ j0j lt

an1 þ b0n1 ðc þ rxt Þ  an  b0n xt þ ð1=2Þb0n1 SS0 bn1 ¼ b0n1 lt ð7Þ

for
0 1
X
J X
N
0@
lt ¼ gSS qjt jj þ z[t b[1 A: (8)
j¼1 [¼1

Suppose we conjecture that in equilibrium the positions qjt ; znt selected by arbitrageurs are themselves
affine functions of the vector of factors, so that

lt ¼ l þ Lxt : (9)
Then (7) requires

b0n ¼ b0n1 r  b0n1 L (10)

an ¼ an1 þ b0n1 c þ ð1=2Þb0n1 SS0 bn1  b0n1 l: (11)

From (5), the left side of (7) is the approximate expected return to a $1 long position in an n-period
contract entered at date t: Equation (7) thus characterizes equilibrium expected returns in terms of the
price of risk lt :
 
Fn1;tþ1  Fnt 0
Et zbn1 lt : (12)
Fnt
In the special case of risk-neutral arbitrageurs (g ¼ 0), from (8) we would have l ¼ 0 and L ¼ 0 in (9).
Note that this framework allows for all kinds of factors (as embodied in the unobserved values of xt )
to influence commodity futures prices through Equation (4), including interest rates, fundamentals
affecting supply and demand, and factors that might influence risk premia in other asset markets. If we
consider physical inventory as another possible asset qjt ; this may help offset the risks associated with
futures positions z[t as described in Equation (8) and could also be an element of the hypothesized
factor vector xt . We will demonstrate below that it is not necessary to have direct observations on the
factor vector xt itself in order to make use of the model’s primary empirical implications (10) and (11).
Instead, these restrictions can be represented solely in terms of implications for the dynamic behavior
of the prices of different commodity-futures contracts that have to hold as a result of the factor
structure itself and the behavior of the arbitrageurs. Moreover, we will see that it is possible to estimate
the risk-pricing parameters l and L solely on the basis of any predictabilities in the returns from
positions in commodity-futures contracts.3

3
Alternatively, one can try to make use of direct observations on the positions of commodity index-fund investors as we do
in Hamilton and Wu (2012c).
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 13

The recursions (10) and (11) can equivalently be viewed as the equilibrium conditions that would
result if risk-neutral arbitrageurs were to regard the factor dynamics as being governed not by (3) but
instead by

xtþ1 ¼ cQ þ rQ xt þ SuQ
tþ1 (13)

cQ ¼ c  l (14)

rQ ¼ r  L ð15Þ
Q
uQ
tþ1 wNð0; Im Þ:

The recursions (10) and (11) that characterize the relation between the prices of futures contracts of
different maturities will be recognized as similar to those that have been developed in the affine term
structure literature4 to characterize the relations that should hold in equilibrium between the interest
rates on assets of different maturities. In addition to providing a derivation of how these relations can
be obtained in the case of commodity futures contracts, the derivation above demonstrates how
commercial hedging or commodity-index funds might be expected to influence commodity futures
prices. An increase in the demand for long positions in contract n will require in equilibrium a price
process in which arbitrageurs are persuaded to take a corresponding short position in exactly that
amount. A larger absolute value of znt in turn will expose arbitrageurs to different levels of risk which
would change the equilibrium compensation to risk lt according to equation (8). Again, from (8) and
(9), these index traders could be responding through an affine function to interest rates or other
economic fundamentals. What matters is that this behavior causes the net risk exposure of arbitrageurs
lt to be an affine function of the factors in equilibrium. In the following subsection we illustrate this
potential effect using a simple example.

2.2. Example of the potential role of index-fund traders

Suppose there are some investors who always want to have a long position in the 2-period contract,
regardless of anything happening to fundamentals. At the start of each new period, these investors close
out their previous position (which is now a 1-period contract) and replace it with a new long position in
what is now the current 2-period contract.5 Let the scalar Kt denote the notional value of 2-period
contracts that investors want to buy in period t, and suppose this evolves exogenously according to

Kt ¼ cK þ rK Kt1 þ SK uKt : (16)

If investors and arbitrageurs are the only participants in the market, then equilibrium futures prices
must be such as to persuade arbitrageurs to take the opposite side of the investors. Thus arbitrageurs
are always short the two-period contract, close that position when it becomes a 1-period contract, take
the short side of the new 2-period contract, and have zero net exposure to any other contract in
equilibrium. In other words, the process for ffnt gN
n¼0 must be such that (7) and (8) are satisfied with

4
Our recursions (10) and (11) are essentially the same as Equation (17) in Ang and Piazzesi (2003), with the important
difference being that their recursion for the intercept adds a term d0 for each n; corresponding to the interest earned each
period. No such term appears in our expression because there is no initial capital invested. Another minor notational difference
is that our l corresponds to their Sl0 while our L corresponds to their Sl1 : An advantage of our notation in the current setting
is that our lt is then measured in the same units as xt and is immediately interpreted as the direct adjustment to c and r that
results from risk aversion by arbitrageurs.
5
In the case of crude oil contracts, what typically happens is that the commodity-index fund takes a long position from a
swap dealer which in turn hedges its exposure by taking a long position in an organized exchange contract. We view the swap
fund in such an arrangement as simply an intermediary, with the ultimate demand for the long position ðKt Þ coming from the
commodity-index fund and the index-fund’s ultimate counterparty being the short on the organized exchange contract (z2t ).
14 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37


Kt for n ¼ 2
znt ¼ :
0 otherwise
Suppose that arbitrageurs’ only risk exposure comes from commodities (qjt ¼ 0 for j ¼ 1; .; J). Then
from (8), in equilibrium we will have

lt ¼ gSS0 b1 Kt : (17)
Suppose that the spot price depends solely on a scalar “fundamentals” factor xt :

f0t ¼ xt ð18Þ

xt ¼ c þ r xt1 þ S ut :

We conjecture that in equilibrium, the factor xt governing futures prices includes both fundamentals
0
and the level of index-fund investment, xt ¼ ðxt ; Kt Þ0 , with (18) implying b0 ¼ ð1; 0Þ and the factor
evolving according to

xt ¼ c þ rxt1 þ Sut
or written out explicitly,

xt c r 0 xt1 S 0 ut

¼ þ þ :
Kt cK 0 rK Kt1 0 SK uKt

We can then recognize (17) as a special case of (9) with

l¼0
h i
L ¼ 0 gSS0 b1 :
ð22Þ

Hence

r 0
rQ ¼ þ ½ 0 gSS0 b1  (19)
0 rK

b01 ¼ b00 rQ
 
¼ 1 0 rQ
h h i i
¼ r g ðS Þ2 0 b1
2 3
r
b1 ¼ 4 5:
gr ðS Þ2 ð20Þ

Assuming r > 0 and Kt > 0; the effect of index-fund buying of the 2-period contract is also to increase
the price of a 1-period contract. The reason is that the 2-period contract that the arbitrageurs are
currently being induced to short exposes the arbitrageurs to risk associated with uncertainty about the
value of xtþ1 : The 1-period contract is also exposed to risk from xtþ1 : If a 1-period contract purchased at t
provided zero expected return, arbitrageurs would want to go long the 1-period contract in order to
diversify their risk associated with being short the 2-period contract. But there is no counterparty who
wants to short the 1-period contract, so equilibrium requires a price f1t such that someone shorting the
1-period contract would also have a positive expected return, earned in the form of a higher price for f1t :
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 15

Table 1
Weekly durations associated with monthly contracts at different points in time.

j k ¼ 0 k ¼ 1 k ¼ 2
1 3 7 11
2 2 6 10
3 1 5 9
4 0 4 8

For specified week of the month j and months until the contract expires k, table entry indicates weeks n
remaining until expiry.
0
Substituting (20) into (19), we now know rQ and can calculate bn ¼ ðrQ Þn b0 for each n: Thus in-
vestment buying does not matter for f0t but does affect every fnt for n > 0; through the same mech-
anism as operates on the 1-period contract. In particular, from (12),
 
Fn1;tþ1  Fnt 0 n2
Et z  gb1 rQ SS0 b1 Kt ;
Fnt
which in general has the opposite sign of Kt for all n; someone would earn a positive expected return by
taking the short position in a contract of any duration.

2.3. Empirical implementation

There are two general strategies for empirical implementation of this framework. The first is to
make direct use of data on the positions of different types of traders. Hamilton and Wu (2012c) use this
approach to study agricultural futures prices. Unfortunately, the data publicly available on trader po-
sitions in crude oil futures contracts have some serious problems (see the discussion in Irwin and
Sanders (2012) and Hamilton and Wu (2012c)). An alternative approach, which we adopt for pur-
poses of modeling crude oil futures prices in this paper, is to infer the factors xt based on the behavior of
the futures prices themselves. In this case, risk premia are identified from differences between
observed futures prices and a rational expectation of future prices. We will use the framework to
characterize the dynamic behavior of risk premia and their changes over time.
For purposes of empirical estimation we interpret t as describing weekly intervals. This allows us to
capture some key calendar regularities in the data without introducing an excessive number of pa-
rameters. NYMEX crude oil futures contracts expire on the third business day prior to the 25th calendar
day of the month prior to the month on which the contract is written. To preserve the important
calendar structure of the raw data, we divide the “month” leading up to a contract expiry into four
“weeks”, defined as follows:

week 1 ends on the last business day of the previous calendar month
week 2 ends on the 5th business day of the current calendar month
week 3 ends on the 10th business day of the current calendar month
week 4 ends on the day when the near contract expires

Associated with any week t is an indicator jt ˛f1; 2; 3; 4g of where in the month week t falls.
Our estimation uses the nearest three contracts. If we interpret the price at expiry as an n ¼ 0
week-ahead contract, the observation yt for week t would be characterized using the notation of
Section
8 2 as follows:
>
> 0
>
> f3t ; f7t ; f11;t if jt ¼ 1
>
>
>
>
>
>
0
< f2t ; f6t ; f10;t if jt ¼ 2
yt ¼ 0 :
>
>
>
> f1t ; f5t ; f9t if jt ¼ 3
>
>
>
> 0
>
>
: f0t ; f4t ; f8t if jt ¼ 4
16 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

Level
5

2
1990 1995 2000 2005 2010

Slope
0.1

0.05

−0.05

−0.1
1990 1995 2000 2005 2010

Fig. 1. Data used in the analysis. Weekly observations (with specification of weeks as given in text), January 1990 to June 2011. Top
panel: first element of y1t (the average of the log prices of second and third contracts). Bottom panel: second element of y1t (the
difference between the log price of third and second contracts).

Table 1 summarizes the relation between the weekly indicator (j), months until expiry is reached ðkÞ,
and weeks remaining until expiry ðnÞ. This feature that the maturity of observed contracts changes
with each observation t is one reason that much of the research with commodity futures contracts has
used monthly data. However, in our application a key interest is in the higher-frequency movements
and specific calendar effects. Fortunately, the framework developed in Section 2 gives us an exact
description of the likelihood function for the data as actually observed, as we now describe.
We will assume that there are two underlying factors (that is, xt is 2  1) Since (4) implies that each
element of the (3  1) vector yt could be written as an exact linear function of xt ; the system as written is
stochastically singular – according to the model, the third element of yt should be given by an exact
linear combination of the first two. This issue also commonly arises in studies of the term structure of
interest rates. A standard approach in that literature6 is to assume that some elements or linear com-
binations of yt differ from the magnitude predicted in (4) by a measurement or specification error. In the
results reported below, we assume that the k ¼ 1 - and 2- month contracts are priced exactly as the
model predicts. It is helpful for purposes of interpreting parameter estimates to summarize the infor-
mation in these contracts in terms of the average level of the two prices, which we will associate with
the first factor in the system, and spread between them, which we will associate with the second factor:

y1t ¼ H1 yt

2 3
6 0 ð1=2Þ ð1=2Þ 7
6 7 ð21Þ
H1 ¼ 6 7:
4 5
0 1 1

The two elements of y1t are plotted in Fig. 1.

We assume that the model correctly characterizes these two observed magnitudes. Since
yt ¼ ðf4jt ; f8jt ; f12jt Þ0 , this implies that

6
See for example Chen and Scott (1993), Ang and Piazzesi (2003) and Joslin et al. (2011). The observable implications of this
assumption are explored in detail in Hamilton and Wu (2013).
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 17

y1t ¼ A1;jt þ B1;jt xt (22)

2 3
a4jt
6 7
6 7
A1;jt ¼ H1 6 a8jt 7 for jt ¼ 1; 2; 3; or 4
ð21Þ
4 5
a12jt
2 3
b04jt
6 7
6 7
6 0 7 ð23Þ
B1;jt ¼ H1 6 b8jt 7 for jt ¼ 1; 2; 3; or 4:
6 7
ð22Þ 4 5
b012jt
We will use the notational convention that if jt ¼ 1; then A1;jt1 ¼ A14 :
If B1j is invertible, the dynamics of the observed vector y1t can be characterized by substituting (22)
into (3):
h i
y1t ¼ A1;jt þ B1;jt c þ B1;jt r B1
1;jt1 y1;t1  A1;jt1 þ B1;jt Sut :

Since ut is independent of fyt1 ; yt2 ; .; y0 g; this means that the density of y1t conditional on all
previous observations is characterized by a VAR(1) with seasonally varying parameters:

y1t yt1 ; yt2 ; .; y0 wN fjt þ Fjt y1;t1 ; Ujt (24)

Ujt ¼ B1;jt SS0 B01;jt

Fjt ¼ B1;jt rB1

1;jt1

fjt ¼ A1;jt þ B1;jt c  Fjt A1;jt1 :

Note that the predicted seasonal parameter variation arises from the fact that the number of weeks
remaining until expiry of the observed contracts changes with each new week.
We postulate that the nearest contract, which we write as
y2t ¼ H2 yt

H2 ¼ ½ 1 0 0 ; (25)
differs from the value predicted by the framework by a measurement or specification error with mean
zero and variance s2e;jt :
y2t ¼ A2;jt þ B2;jt xt þ se;jt ue;t

2 3
a4jt
A2;jt ¼ H2 4 a8jt 5 for j ¼ 1; 2; 3; 4
ð11Þ a12jt

2 3
b04jt
6 0 7
B2;jt ¼ H2 4 b8jt 5 for jt ¼ 1; 2; 3; or 4:
ð12Þ 0
b12jt
18 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

If the measurement error uet is independent of past observations, this gives the conditional
distribution

y2t jy1t ; yt1 ; yt2 ; .:; y0 wN gjt þ Gjt y1t ; s2e;jt (26)

Gjt ¼ B2;jt B1

1;jt (27)

gjt ¼ A2;jt  Gjt A1;jt :

The density of yt conditional on its own past history is thus the product of (24) with (26), meaning
that the log likelihood for the full sample of observations ðy0T ; y0T1 ; .; y01 Þ0 conditional on the initial
observation y0 is given by

T h
X i
L ¼ log g y1t ; fjt þ Fjt y1;t1 ; Ujt þ log g y2t ; gjt þ Gjt y1t ; s2e;jt (28)
t ¼1

where gðy; m; UÞ denotes the multivariate Normal density with mean m and variance U evaluated at the
point y.

3. Estimation

3.1. Unrestricted reduced form

The traditional approach to estimation of these kind of models would be to maximize the likelihood
function with respect to the unknown structural parameters. However, Hamilton and Wu (2012b)
demonstrate that there can be big benefits from using an estimator that turns out to be asymptoti-
cally equivalent to MLE but is derived from simple OLS regressions. To understand this estimator,
consider first how we would maximize the likelihood if we thought of fj ; Fj ; Uj ; gj ; Gj ; and sej in the
above representation as completely unrestricted parameters rather than the particular values implied
by the structural model presented above. From this perspective, the log likelihood (28) could be written

X
4 X
4
Lðf1 ; F1 ; U1 ; g1 ; G1 ; se1 ; .; f4 ; F4 ; U4 ; g4 ; G4 ; se4 Þ ¼ L1j fj ; Fj ; Uj þ L2j gj ; Gj ; sej (29)
j¼1 j¼1

X
T
L1j fj ; Fj ; Uj ¼ dðjt ¼ jÞlog g y1t ; fj þ Fj y1;t1 ; Uj
t ¼1

0
log g y1t ; fj þ Fj y1;t1 ; Uj ¼ log 2p  ð1=2Þlog Uj  ð1=2Þ y1t  fj  Fj y1;t1 U1
j y1t  fj

 Fj y1;t1

X
T
L2j gj ; Gj ; sej ¼ dðjt ¼ jÞlog g y2t ; gj þ Gj y1t ; s2ej
t¼1
2
y2t  gj  Gj y1t
log g y2t ; gj þ Gj y1t ; s2ej ¼ ð1=2Þlog 2p  ð1=2Þlog s2ej 
2s2ej
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 19

where for example dðjt ¼ 1Þ is 1 if t is in the first week of the month and is zero otherwise. It is clear
that the unconstrained likelihood function is in fact maximized by a series of OLS regressions. To es-
timate the parameters in block j; we collect all observations whose left-hand variable is in the jth week
of the month, and simply perform OLS regressions on what now looks like a monthly data set.
Specifically, to estimate ðfj ; Fj ; Uj Þ for a particular j; we associate month s with an observed
monthly-frequency vector yy1;j;s defined as follows. For illustration, consider j ¼ 1 and suppose that s
corresponds to the month spanned by the last week of December and first 3 weeks of January. The
first element of yy1;1;sjmonthðsÞ¼Jan is the average of the log prices of the March and April contracts as of
the last business day of December. The second element of yy1;1;sjmonthðsÞ¼Jan is based on the log price of
the April contract on the last day of December minus the log price of March contract. For j ¼ 1 and
general s,
2 3
f3;tðsÞ
yy1;1;s ¼ H1 f7;tðsÞ 5
4
f11;tðsÞ

for H1 given in (21) and where tðsÞ denotes the week t associated with month s. The explanatory
variables in these j ¼ 1 block regressions consist of a constant, the average log prices of the February
and March contracts on the day in December when the January contract expired, and the spread be-
tween the March price and February price at the December expiry of the January contract:
2 3
2 1 3
6 f0;tðsÞ1 7
xy1;1;s ¼ 6 7
4 H1 4 f4;tðsÞ1 5 5: (30)
f8;tðsÞ1

Consider the estimates from OLS regression of yy1;1;s on xy1;1;s ,

! !1
h i X
T X
T
b b y y0 y y0
f 1 F 1
¼ y1;1;s x1;1;s x1;1;s x1;1;s
s¼1 s¼1

X
T h i h i 0
b ¼ T 1
U yy1;1;s  fb b xy yy1;1;s  fb b xy
1 1 F 1 1;1;s 1 F 1 1;1;s
s¼1

where T denotes the number of months in the sample. These estimates maximize the log likelihood
(29) with respect to ff1 ; F1 ; U1 g
y
For j ¼ 2 we regress y1;2;s (whose first element, for example, would be the average of the March and
April contracts as of the fifth business day in January) on xy1;2;s (e.g., a constant and the level and spread
as of the last day of December),
! !1
h i X
T X
T
b
f b
2 F2
¼ yy1;2;s xy0
1;2;s xy1;2;s xy0
1;2;s
s¼1 s¼1

X
T h i h i 0
b ¼ T 1 y
y1;2;s  fb b xy y
y1;2;s  fb b xy
1;2;s ;
U 2 2 F 2 1;2;s 2 F 2
s¼1

to obtain f b ; and U
b ; F b : Similar separate monthly regressions of the 1- and 2-month prices in the
2 2 2
third or fourth week of each month on their values the week before produce f f b ;F b g for j ¼ 3 or 4.
b ;U
P j j j
Likewise, note that the components of 4j¼1 L2j ðgj ; Gj ; se Þ take the form of regressions in which the
residuals are uncorrelated across blocks, meaning full-information maximum likelihood estimates of gj
20 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

and Gj are obtained by OLS regressions for individual j: For example, for j ¼ 1 and s corresponding to
December–January, yy2;j;s is the price of the February contract on the last day of December,
2 3
f3;tðsÞ
yy2;1;s ¼ H2 4 f7;tðsÞ 5;
f11;tðsÞ

for H2 in (25) and explanatory variables the level and slope as of the last day of December:
2 3
2 1 3
y 6 f3;tðsÞ 7
x2;1;s ¼ 6 7
4 H1 4 f7;tðsÞ 5 5:
f11;tðsÞ

The maximum likelihood estimates are given by

! !1
h i X
T X
T
gb j ^
G ¼
y y0
y2;j;s x2;j;s
y y0
x2;j;s x2;j;s for j ¼ 1; 2; 3; 4
j
s¼1 s¼1
X
T h i 2 ð31Þ
s 2ej ¼ T 1
b y
y2;j;s  gbj ^ xy
G :
j 2;j;s
s¼1

3.2. Structural estimation of the baseline model

Now consider estimation of the underlying structural parameters of the model presented in Section
b ;U
b ;F b ;g ^ s ; .; fb ;Fb ;Ub ;
2. The key point to note is that the above OLS estimates f f 1 1 1 b 1 ; G1 ; b e1 4 4 4
b ^
g 4 ; G4 ; s e4 g are sufficient statistics for inference about these parameters – anything that the full sample
b
of data is able to tell us about the model parameters can be summarized by the values of these OLS
estimates. The idea behind the minimum-chi-square estimation proposed by Hamilton and Wu (2012b)
is to choose structural parameters that would imply reduced-form coefficients as close as possible to the
unrestricted estimates, an approach that turns out to be asymptotically equivalent to full MLE.
Note that the model developed here specifies observed prices in terms of an unobserved factor
vector xt . There is an arbitrary normalization in any such system, in that if we were to multiply xt by a
nonsingular matrix and add a constant, the result would be observationally equivalent in terms of the
implied likelihood for observed yt :7 Since we have treated the factors xt as directly inferable from the
values of y1t ; we normalize the factors so that they could be interpreted as the level and slope as of the
date of expiry of the near-term contract:
xt ¼ H1 yt for jt ¼ 4: (32)
Recalling (22), this would be the case if
2 3 2 3
a0 b00
H1 yt ¼ H1 a4 þ H1 b04 5xt for jt ¼ 4:
4 5 4 (33)
a8 b08
Substituting (32) into (33), our chosen normalization thus calls for
2 3 2 3
a0 b00
xt ¼ H1 a4 þ H1 b04 5xt for jt ¼ 4
4 5 4
a8 b08

7
For further discussion of identification and normalization, see Hamilton and Wu (2012b).
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 21

2 3
b00
H1 4 b04 5 ¼ I2 (34)
b08

2 3
a0
H1 4 a4 5 ¼ 0: (35)
a8
Since
2 3 2 3 2 0 3
f0t a0 b0
4 f4t 5 ¼ 4 a4 5 þ 4 b0 5xt ;
4
f8t a8 b08
our normalization could alternatively be described as xt ¼ H1 ðf0t ; f4t ; f8t Þ0 for all t: Following Joslin et al.
(2011) and Hamilton and Wu (2013), this can be implemented by defining x1 and x2 to be the eigen-
values of rQ ¼ r  L. Given this normalization and values for x1 ; x2 ; S; and a0 ; we can then determine
N
the values for rQ ; cQ ; and fbn ; an gn¼0 ; details are provided in Appendix B. These along with r; c, and se
then provide everything we need to evaluate the likelihood function or to calculate what the predicted
values for any of the unrestricted reduced-form coefficients ought to be.
Let q denote the vector of unknown structural parameters, that is, the 16 elements of
fx1 ; x2 ; S; a0 ; r; c; se1 ; se2 ; se3 ; se4 g for S lower triangular. Collect elements of the unrestricted OLS es-
timates in a vector p b:
 0
b 0F ; p
b ¼ p
p b 0U ; p
b 0G ; p
bs

h h i0 i 0 h h i0 i0 0
bF ¼
p vec fb b
F ; .; vec fb b
F
1 1 4 4

h i0 h i0 0
bU ¼
p b
vech U b
; .; vech U
1 4

h h i0 i0 h h i0 i0 0
bG ¼
p vec gb1 ^
G ; .; vec gb4 ^
G
1 4

b s ¼ ðs
p b e1 ; s
b e2 ; s b e4 Þ0 :
b e3 ; s

Let gðqÞ denote the corresponding predicted values for those coefficients from the model; specific
values for the elements of gðqÞ are summarized in Appendix C. The minimum-chi-square (MCS) esti-
mate of q is the value that minimizes

T ½p bp
b  gðqÞ0 R½ b  gðqÞ (36)
b the information matrix associated with the OLS estimates p
for R b ; which is also detailed in Appendix C.
The MCS estimator has the same asymptotic distribution as the maximum likelihood estimator, but has
a number of computational and interpretive advantages over MLE discussed in Hamilton and Wu
(2012b). Because Rb is block-diagonal with respect to ps ; the MCS estimates of these parameters are
given immediately by the OLS estimates (31). Hamilton and Wu (2012b) show that asymptotic standard
errors can be estimated using
22 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

5
x 10
18

16

14

12

10

0
1985 1990 1995 2000 2005 2010 2015

Fig. 2. Open Interest. Total number of outstanding crude oil futures contracts of all maturities, daily observations, March 3, 1983 to
July 17, 2011. Vertical lines drawn at January 1, 1990 and January 1, 2005.

0 1
E b
q  q0 b
qq b0R
xT 1 G bGb
0

b ¼ vgðqÞ
G
vq q¼bq ;
0

which are identical to the usual asymptotic errors that would be obtained by taking second derivatives
of the log likelihood function (28) with respect to q:

4. Empirical results for the baseline model

Crude oil futures contracts were first traded on the New York Mercantile Exchange (NYMEX) in
1983. In the first few years, volume was much lighter than the more recent data, and we choose to
begin our empirical analysis in January, 1990. Fig. 2 plots the total open interest on all NYMEX light
sweet crude contracts. Volume expanded very quickly after 2004, in part in response to the increased
purchases of futures contracts as a vehicle for financial diversification. Some researchers have sug-
gested that participation in the markets by this new class of traders resulted in significant changes in
the dynamic behavior of crude oil futures prices.8 A likelihood ratio test (e.g., Hamilton (1994, p. 296))
of the null hypothesis that the coefficients of the unrestricted reduced form are constant over time
against the alternative that all 52 parameters changed in January 2005 produces a c2 ð52Þ statistic of
181.96, which calls for dramatic rejection of the null hypothesis (p value of 2:2  1016 ). Since one of
our interests in this paper is to document how futures price dynamics have changed over time, we
conduct our analysis on two subsamples, the first covering January 1990 through December 2004, and
the second January 2005 through June 2011.
The left panel of Table 2 reports minimum-chi-square estimates of the 16 elements of q based on the
first subsample. The eigenvalues of r; the matrix summarizing the objective P-measure persistence of

8
See for example Alquist and Kilian (2007), Singleton (2011), Tang and Xiong (2012), Mou (2010), and Buyuksahin and Robe
(2011).
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 23

Table 2
Pre-2005 parameter estimates for baseline model.

Estimated parameters Implied parameters

c 0.0102 0.0016 l 0.0104 0.0061*
(0.0209) (0.0029) (0.0209) (0.0029)
r 0.9974* 0.1839* L 0.0023 0.0591
(0.0067) (0.0918) (0.0067) (0.0918)
0.0006 0.9301* 0.0020* 0.0050
(0.0009) (0.0134) (0.0009) (0.0136)
x 0.9876* 0.9473* l þ Lx 0.0037* 3.53e-005
(0.0010) (0.0044) (0.0018) (2.63e-004)
S 0.0449* 0
(0.0012)
0.0038* 0.0047*
(0.0002) (0.0001)
a0 0.0357*
(0.0007)
ps 0.0099* 0.0081*
(0.0005) (0.0004)
0.0105* 0.0201*
(0.0006) (0.0011)

Left panel: MCS estimates of elements of q for data from January 1990 through December 2004 (asymptotic standard errors in
parentheses). Right panel: assorted magnitudes of interest implied by value of b
q (asymptotic standard errors in parentheses). *
denotes statistically significant at the 5% level.

factors, are 0.9956 and 0.9319, implying that both level and slope are highly persistent, with similar
estimates for their Q-measure counterparts (x1 and x2 ).
The differences between the P- and Q-measures, or implied characterization of lt ; are reported
in the right panel of Table 2.9 The individual elements of l and L are generally small and statis-
tically insignificant. The last two entries of Table 2 report the elements of l þ Lx; where x is the
average value for the level and spread over the sample. The positive value of 0.0037 for the first
element of this vector suggests that an investor who was always long in the two contracts would on
average have come out ahead over this period, an estimate that is just statistically significant at the
5% level.10
Table 3 reports parameter estimates for the later subsample, in which there appear to be significant
differences in risk pricing from the earlier data. Most noteworthy is the large negative value for L12 :
This signifies that when the spread (the second element of xt ) gets sufficiently high, a long position in
the 1- and 2-month contracts would on average lose money. We also see from the last entry of Table 3
that the first element of l þ Lx is smaller in the second subsample than in the first, and is no longer
statistically significant. The average reward for taking long positions in the second subsample is not as
evident as in the first subsample.
Fig. 3 plots our estimated values for lt ¼ l þ Lxt for each week t in our sample, along with 95%
confidence intervals. The price of level risk (top panel) was uniformly positive up until 2006, but has
often been negative since 2008. By contrast, slope risk (bottom panel) was typically not priced before
2004, whereas going long the 2-month contract and short the 1-month has frequently been associated
with positive expected returns since then.11

9
Standard errors for l and L were obtained by reparameterizing the MCS estimation in terms of l and L instead of c and r.
The values of l and L can be obtained analytically from l ¼ c  cQ and L ¼ r  rQ with cQ given by equation (47) and rQ given
by equation (42).
10
Note from (12) and (34) that the expected return on a portfolio with equal weights on the second and third contracts is
0 0
given by ð1=2Þðb4 þ b8 Þlt ¼ ½ 1 0 lt whose average value is the first element of l þ Lx:
11
From (12) and (34), the expected return on a portfolio that is long the third contract and short the second is given by
0 0
ðb8  b4 Þlt ¼ ½ 0 1 lt whose average value is the second element of l þ Lx:
24 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

Table 3
Post-2005 parameter estimates for baseline model.

Estimated parameters Implied parameters

c 0.1802* 0.0164* l 0.1813* 0.0179*
(0.0574) (0.0070) (0.0574) (0.0070)
r 0.9600* 0.3487 L 0.0400* 0.5892*
(0.0131) (0.2018) (0.0131) (0.2018)
0.0035* 0.8629* 0.0039* 0.0311
(0.0016) (0.0241) (0.0016) (0.0243)
x 1.0010* 0.8931* l þ Lx 0.0028 0.0009*
(0.0001) (0.0047) (0.0026) (0.0003)
S 0.0439* 0
(0.0019)
0.0021* 0.0049*
(0.0003) (0.0002)
a0 0.0086*
(0.0009)
ps 0.0059* 0.0086*
(0.0005) (0.0007)
0.0087* 0.0223*
(0.0007) (0.0018)

Left panel: MCS estimates of elements of q for data from January 2005 through June 2011 (asymptotic standard errors in pa-
rentheses). Right panel: assorted magnitudes of interest implied by value of b
q (asymptotic standard errors in parentheses). *
denotes statistically significant at the 5% level.

Level risk price

0.05

−0.05

1990 1995 2000 2005 2010

−3
x 10 Slope risk price
5

−5
1990 1995 2000 2005 2010

Fig. 3. Prices of factor risk. Top panel: first element of l þ Lxt as estimated from baseline model, with sample split in 2005. Bottom
panel: second element. Dashed lines indicate 95% confidence intervals.

Following Cochrane and Piazzesi (2009) and Bauer et al. (2012), another way to summarize the
implications of these results is to calculate how different the log price of a given contract would be if
there was no compensation for risk. To get this number, we calculate ~f nt ¼ a ~n þ b~ x ; where b
~ and a ~n
n t n
denote the values that would be obtained from the recursions (10) and (11) if L and l were both set to
zero. The value for the difference ~f nt  fnt for n ¼ 8 weeks is plotted in Fig. 4. In the absence of risk
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 25

8−week risk premium

0.2

0.15

0.1

0.05

−0.05

−0.1

−0.15

−0.2
1990 1995 2000 2005 2010

Fig. 4. Risk premium on 8-week futures contract. Plot of ~f 8t  f8t as estimated from the baseline model with sample split in 2005.

effects, an 8-week contract price would have been a few percent higher on average over the 1990–2004
subsample.12 Since 2005, risk aversion has made a more volatile contribution, though the average
effect is significantly smaller.
In terms of the framework proposed in Section 2 for interpreting these results, the positive average
value for the first element of lt in the first subsample suggests that arbitrageurs were on average long
in crude oil futures contracts over this period, accepting the positive expected earnings from their
positions as compensation for providing insurance to sellers, who were presumably commercial
producers who wanted to hedge their price risks by selling futures contracts. From that perspective, an
increase in index fund buying could have been one explanation for why a long position in futures
contracts no longer has a statistically significant positive return. In effect, index-fund buyers are
serving as counterparty for commercial hedgers, and are willing to do so without the risk compen-
sation that the position earned on average in the first subsample. The emerging positive return to a
spreading position (positive average second element of lt in the second subsample) would be
consistent with the view that arbitrageurs are buying and holding 2-month futures from oil producers,
but then selling these positions and going short 1-month futures as they sell to index-fund investors.
As noted by Hamilton and Wu (2012b), another benefit of estimation by minimum chi square is that
the optimized value for the objective function provides an immediate test of the overall framework.
Under the null hypothesis that the model is correctly specified, the minimum value achieved for (36)
has an asymptotic c2 distribution with degrees of freedom given by the number of overidentifying
restrictions. The first column of Table 4 reports the value of this statistic for each of the two subsamples.
The model is overwhelmingly rejected in either subsample.
Because the weighting matrix R b in (49) is block-diagonal, it is easy to decompose these test statistics
into components coming from the respective elements of p; as is done in subsequent columns of Table

12
The average size of this risk premium is 2.9% for the first sample. This compares with an average realized 2-month ex post
return over this period of 2.0% for the long position on a 3-month contract (that is, the average log value of the first contract
minus the average log value of the third contract two months earlier), and an average difference between the first contract and
third contract at the same date of 1.2% (that is, the futures curve sloped down on average with a slope of 1.2%). The last
number is similar to the value reported by Alquist and Kilian (2010), who noted that the 3-month futures price was 1.1% below
the spot price on average over 1987–2007. The difference between the average ex post return to the long position and the
negative of the average slope results from the significantly higher price of oil at the end of the sample than at the beginning.
26 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

Table 4
c2 specification test and breakdown by individual components.
c2 d:f : p-value pF pU pG
Before 2005 86.57 36 4.73e-6 25.61 43.98 16.99
Since 2005 151.87 36 3.33e-16 120.01 17.22 14.64

c2 : minimum value achieved for MCSE objective function. d:f :: degrees of freedom. p-value: probability of observing c2 ðd:f :Þ
value this large. Last 3 columns: contribution to c2 of individual parameter blocks.

4. In the first subsample, about half of the value of the test statistic comes from the pU block – the
differences in the variability of the level and slope across different weeks of the month is more than can
be explained by the fact that the maturities of observed contracts are changing week to week. The
biggest problem in the second subsample come from the pF block – unrestricted forecasts of the level
and slope vary more week-to-week than is readily explained by differences in the maturities of the
contracts.
It is also possible to look one parameter at a time at where the structural model misses. For each of
the unrestricted reduced-form parameters p there is a corresponding prediction from the model gðqÞ
for what that value is supposed to be if the model is correct. Figs. 5 and 6 plot the unrestricted OLS
estimates of the various elements of p along with their 95% confidence intervals for the first subsample.
The thick red lines indicate the value the coefficient is predicted to have according to the structural
parameters reported in Table 2. The biggest problems come from the fact that the model underpredicts
the difficulty of forecasting the spread in weeks 1 and 3 (the lower left panel of Fig. 6). Figs. 7 and 8
provide the analogous plots for the second subsample. Here the biggest problems come from the
fact that the equations one would want to use to forecast the spread in weeks 3 and 4 are quite different

φ1 φ2
0.2 0.05

0 0

−0.2 −0.05
1 2 3 4 1 2 3 4
Φ11 Φ21
1.2 0.02

1 0

0.8 −0.02
1 2 3 4 1 2 3 4
Φ Φ
12 22
1 1.5

0 1

−1 0.5
1 2 3 4 1 2 3 4

Fig. 5. pF before 2005. Light blue line: Unrestricted OLS estimates of coefficients for regression in which y1t is the dependent
variable, plotted as a function of week of the month. Dashed blue lines: 95% confidence intervals for unrestricted OLS estimates. Bold
red line: predicted values for coefficients derived from baseline model. All estimates based on data January 1990 to December 2004.
(For interpretation of the references to colour in this figure legend, the reader is referred to the web version of this article.)
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 27

−3 Ω11 γ
x 10
3 0.1

2 0

1 −0.1
1 2 3 4 1 2 3 4
−4 Ω21 Γ1
x 10
0 1.05

−2 1

−4 0.95
1 2 3 4 1 2 3 4
−5 Ω22 Γ2
x 10
6 −1.5

4 −2

2 −2.5
1 2 3 4 1 2 3 4
Fig. 6. pU and pG before 2005. First column: estimated elements of variance-covariance matrix for regression in which y1t is the
dependent variable, plotted as a function of week of the month. Second column: Estimated values of coefficients for regression in
which y2t is the dependent variable, plotted as a function of week of the month. In each panel, light blue lines are unrestricted OLS
estimates, dashed blue lines are 95% confidence intervals for unrestricted OLS estimates, and bold red lines are predicted values for
coefficients derived from baseline model. All estimates based on data January 1990 to December 2004. (For interpretation of the
references to colour in this figure legend, the reader is referred to the web version of this article.)

from those found for weeks 1 and 2 (see the right-hand column of Fig. 7). These considerations suggest
looking at models that allow for more general seasonal variation than our baseline specification, which
we explore in the next section.

5. Less restrictive seasonal models

5.1. Structural estimation

Here we consider a system in which the dynamic process followed by the factors is itself dependent
on which week of the month we are looking at:

xtþ1 ¼ cjt þ rjt xt þ Sjt utþ1 :

If we hypothesize that the risk-pricing parameters also vary with the season,

lt ¼ ljt þ Ljt xt
then the no-arbitrage conditions (10) and (11) generalize to

b0n ¼ b0n1 rQjðnÞ ð37Þ

an ¼ an1 þ b0n1 cQjðnÞ þ ð1=2Þb0n1 SjðnÞ S0jðnÞ bn1 :

28 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

φ φ
1 2
0.5 0.1

0 0

−0.5 −0.1
1 2 3 4 1 2 3 4
Φ Φ21
11
1.2 0.02

1 0

0.8 −0.02
1 2 3 4 1 2 3 4
Φ12 Φ22
5 1.5

0 1

−5 0.5
1 2 3 4 1 2 3 4

Fig. 7. pF since 2005. Light blue line: Unrestricted OLS estimates of coefficients for regression in which y1t is the dependent variable,
plotted as a function of week of the month. Dashed blue lines: 95% confidence intervals for unrestricted OLS estimates. Bold red line:
predicted values for coefficients derived from baseline model. All estimates based on data January 2005 to June 2011. (For inter-
pretation of the references to colour in this figure legend, the reader is referred to the web version of this article.)

where which observation week j is associated with a given maturity n can be read off of Table 1 and
where we have defined rQ j
¼ rj  Lj and cQ j
¼ cj  lj : Unfortunately, if all the parameters were
allowed to vary with the week j in this way, the model would be unidentified. The reason is that even if
one hypothesizes different values of rQ
j
for different j; a generalization of the algebra in (48) still implies
that Gj should be the same for all j:

2 3
b00
Gj ¼ H2 4 b04 5 for j ¼ 1; 2; 3; 4:
b08
0 0 0 0
Since b4 ¼ b0 rQ rQ rQ rQ b rQ rQ rQ rQ
3 2 1 4 and 8 ¼ 4 3 2 1 4 ; the only information available from the regressions in
b
which y2t is the dependent variable (26) is about the product rQ rQ rQ rQ
3 2 1 4 ; which does not allow iden-
tification of the individual terms. In the next subsection we report estimates for a system in which
although cj ; rj ; lj ; and Lj all vary with j; the differences cQ ¼ cj  lj and rQ ¼ rj  Lj do not. For this
system, the flexibility of the cj and rj parameters allows us to fit the unrestricted OLS values for fj and
Fj perfectly. Details of the normalization and estimation for this less restrictive specification are re-
ported in Appendices B and C.

5.2. Empirical results for the less restrictive seasonal model

Empirical estimates for the parameters of the above system for each of the two subsamples are
reported in Tables 5 and 6. In the first subsample, the main differences are that the specification allows
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 29

−3 Ω γ
x 10 11
5 0.2

0 −0.2
1 2 3 4 1 2 3 4
−4 Ω21 Γ
x 10 1
5 1.05

0 1

−5 0.95
1 2 3 4 1 2 3 4
−5 Ω Γ
x 10 22 2
4 −1.5

2 −2

0 −2.5
1 2 3 4 1 2 3 4
Fig. 8. pU and pG since 2005. First column: estimated elements of variance-covariance matrix for regression in which y1t is the
dependent variable, plotted as a function of week of the month. Second column: Estimated values of coefficients for regression in
which y2t is the dependent variable, plotted as a function of week of the month. In each panel, light blue lines are unrestricted OLS
estimates, dashed blue lines are 95% confidence intervals for unrestricted OLS estimates, and bold red lines are predicted values for
coefficients derived from baseline model. All estimates based on data January 2005 to June 2011. (For interpretation of the references
to colour in this figure legend, the reader is referred to the web version of this article.)

the spread to become harder to forecast as the near contract approaches expiry (that is, the (2,2)
element of Sj increases in j) and the level and slope at the end of the month are less related to their
values at expiry than is typical of the relation between y1t and y1;t1 at other times (that is, diagonal
elements of rj are smaller for j ¼ 4). Although implied values for l and L are estimated with much less
precision, the overall conclusion that individual elements are small and statistically insignificant ap-
plies across individual weeks as well.
For the second subsample (Table 6), the dependence of L12;j on week j is very dramatic, with an
average value of 0:78 for j ¼ 1; 2; or 3 but an estimated value of þ0:46 for j ¼ 4: A high spread
signals lower returns to the long position during weeks 1–3, but this effect completely disappears,
and may even take on the opposite sign, during expiry week 4. This may be related to the strong
weekly pattern to index-fund strategies. For example, to replicate the crude oil holdings of the
Goldman Sachs Commodity Index, an index fund would be selling the k ¼ 0 contract and buying the
k ¼ 1 contract during week j ¼ 3: It is interesting that we also find strong weekly patterns in the
pricing of risk in data since 2005, though trying to interpret those changes in detail is beyond the
scope of this paper.
Although our more general specification can fit the unrestricted OLS estimates f b perfectly, it
b and F
j j
still imposes testable overidentifying restrictions on other parameters, essentially using the 3 pa-
b g4 : The resulting c2 ð9Þ MCS test statistic for the
bj; G
rameters in fa0 ; x1 ; x2 g to fit the 12 values for f g j j¼1
first subsample is 13.86, which with a p-value of 0.13 is consistent with the null hypothesis that the
30 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

Table 5
Pre-2005 parameter estimates for seasonal model.

Estimated parameters Implied parameters

cbase 0.0102 0.0016 lbase 0.0104 0.0061*
c1 0.0042 0.0005 l1 0.0044 0.0068
(0.0467) (0.0056) (0.0467) (0.0055)
c2 0.0359 0.0023 l2 0.0356 0.0050
(0.0422) (0.0066) (0.0422) (0.0065)
c3 0.0054 0.0053 l3 0.0051 0.0020
(0.0414) (0.0055) (0.0414) (0.0054)
c4 0.0871* 0.0003 l4 0.0874* 0.0077
(0.0422) (0.0073) (0.0421) (0.0079)
rbase 0.9974* 0.1839* 0.0006 0.9301* Lbase 0.0023 0.0591 0.0020* 0.0050
r1 0.9992* 0.2166 0.0003 0.9369* L1 0.0005 0.0271 0.0022 0.0061
(0.0152) (0.2386) (0.0018) (0.0285) (0.0152) (0.2386) (0.0018) (0.0281)
r2 1.0137* 0.0371 0.0010 0.9825* L2 0.0139 0.2067 0.0015 0.0395
(0.0138) (0.2190) (0.0022) (0.0343) (0.0138) (0.2190) (0.0021) (0.0339)
r3 1.0011* 0.5076* 0.0018 0.9310* L3 0.0014 0.2639 0.0007 0.0120
(0.0135) (0.2061) (0.0018) (0.0274) (0.0135) (0.2061) (0.0018) (0.0270)
r4 0.9726* 0.0718 0.0000 0.8690* L4 0.0272* 0.3155 0.0025 0.0740
(0.0138) (0.2063) (0.0024) (0.0350) (0.0138) (0.2063) (0.0026) (0.0375)
Sbase 0.0449* 0.0038* 0.0047*
S1 0.0491* 0.0042* 0.0039*
(0.0026) (0.0004) (0.0002)
S2 0.0447* 0.0046* 0.0052*
(0.0024) (0.0005) (0.0003)
S3 0.0447* 0.0029* 0.0051*
(0.0024) (0.0004) (0.0003)
S4 0.0446* 0.0035* 0.0059*
(0.0024) (0.0005) (0.0003)
xbase 0.9876* 0.9473*
x 0.9854* 0.9574*
(0.0029) (0.0070)
abase
0 0.0357*
a0 0.0331*
(0.0051)
ps 0.0099* 0.0081* 0.0105* 0.0201*

Left panel: MCS estimates for elements of q (asymptotic standard errors in parentheses) for the unrestricted seasonal model,
with estimates from baseline model also reported for comparison, with all estimates based on data from January 1990 through
December 2004. Elements of matrices reported as first row, then second row. Right panel: values implied by the reported es-
timates of q. * denotes statistically significant at the 5% level.

model has adequately captured all the week-to-week variations in parameters. The second subsample
(c2 ð9Þ ¼ 13:25, p ¼ 0:15) also passes this specification test.

6. Conclusions

In this paper, we studied the interaction between hedging demands from commercial producers or
financial investors and risk aversion on the part of the arbitrageurs who are persuaded to be the
hedgers’ counterparties. We demonstrated that this interaction can produce an affine factor structure
for the log prices of futures contracts in which expected returns depend on the arbitrageurs’ net
exposure to nondiversifiable risk. We developed new algorithms for estimation and diagnostic tools for
testing this class of models appropriate for an unbalanced data set in which the duration of observed
contracts changes with each observation.
Prior to 2005, we found that someone who consistently took the long side of nearby oil futures
contracts received positive compensation on average, with relatively modest variation of this risk
premium over time, consistent with the interpretation that the primary source of this premium was
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 31

Table 6
Post-2005 parameter estimates for seasonal model.

Estimated parameters Implied parameters

cbase 0.1802* 0.0164* lbase 0.1813* 0.0179*
c1 0.0361 0.0106 l1 0.0374 0.0119
(0.1528) (0.0169) (0.1528) (0.0167)
c2 0.2252* 0.0299* l2 0.2264* 0.0286
(0.1094) (0.0147) (0.1094) (0.0144)
c3 0.0508 0.0443* l3 0.0520 0.0456*
(0.1127) (0.0120) (0.1127) (0.0119)
c4 0.1852 0.0102 l4 0.1865 0.0115
(0.1081) (0.0175) (0.1081) (0.0184)
rbase 0.9600* 0.3487 0.0035* 0.8629* Lbase 0.0400* 0.5892* 0.0039* 0.0311
r1 0.9918* 0.4445 0.0021 1.0026* L1 0.0082 0.6847 0.0025 0.1141
(0.0346) (0.5708) (0.0038) (0.0627) (0.0346) (0.5708) (0.0038) (0.0622)
r2 0.9488* 0.5659 0.0066* 1.1369* L2 0.0512* 0.8061* 0.0062 0.2484*
(0.0247) (0.3810) (0.0033) (0.0507) (0.0247) (0.3811) (0.0033) (0.0500)
r3 0.9895* 0.6038 0.0097* 0.6759* L3 0.0105 0.8440* 0.0100* 0.2126*
(0.0257) (0.3454) (0.0027) (0.0367) (0.0257) (0.3454) (0.0027) (0.0364)
r4 0.9592* 0.7020 0.0021 0.8796* L4 0.0409 0.4618 0.0025 0.0089
(0.0245) (0.4244) (0.0040) (0.0661) (0.0245) (0.4244) (0.0042) (0.0684)
Sbase 0.0439* 0.0021* 0.0049*
S1 0.0579* 0.0031* 0.0055*
(0.0047) (0.0007) (0.0005)
S2 0.0423* 0.0013* 0.0054*
(0.0035) (0.0006) (0.0004)
S3 0.0456* 0.0020* 0.0044*
(0.0037) (0.0005) (0.0004)
S4 0.0417* 0.0029* 0.0055*
(0.0034) (0.0007) (0.0005)
xbase 1.0010* 0.8931*
x 1.0008* 0.8877*
(0.0010) (0.0059)
abase
0 0.0086*
a0 0.0077
(0.0106)
ps 0.0059* 0.0086* 0.0087* 0.0223*

Left panel: MCS estimates for elements of q (asymptotic standard errors in parentheses) for the unrestricted seasonal model,
with estimates from baseline model also reported for comparison, with all estimates based on data from January 2005 through
June 2011. Elements of matrices reported as first row, then second row. Right panel: values implied by the reported estimates of
q. * denotes statistically significant at the 5% level.

hedging by commercial producers. However, we uncovered significant changes in the pricing of risk
after the volume of trading in these contracts increased significantly in 2005. The expected compen-
sation from a long position is lower on average in the recent data, often significantly negative when the
futures curve slopes upward. We suggest that increased participation by financial investors in oil fu-
tures markets may have been a factor in changing the nature of risk premia in crude oil futures
contracts.

Appendix A. Approximations to portfolio mean and variance

We first note that if log XwNðm; s2 Þ then EðXÞ ¼ expðm þ s2 =2Þ: Taking a first-order Taylor
approximation around m ¼ s2 ¼ 0 we have EðXÞz1 þ m þ s2 =2: Thus in particular since
 
log Fn1;tþ1 =Fnt wN mn1;t ; s2n1

mn1;t ¼ an1 þ b0n1 ðc þ rxt Þ  an  b0n xt (38)

32 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

s2n1 ¼ b0n1 SS0 bn1 (39)

we have the approximations
  
Et Fn1;tþ1  Fnt Fnt zmn1;t þ s2n1 =2

  
Et exp rj;tþ1 z1 þ xj þ j0j ðc þ rxt Þ þ j0j SS0 jj =2:

Substituting these into (1) gives (5).

Likewise, if
 
log Xi mi sii sij
wN
log Xj mj ; sji sjj ;

then
  h   i   
Cov Xi ; Xj ¼ exp mi þ mj þ sii þ sjj 2 exp sij  1 :

A first-order Taylor expansion around mi ¼ mj ¼ sii ¼ sjj ¼ sij ¼ 0 gives

 
Cov Xi ; Xj zsij :

To use this result we define

0
ytþ1 ¼ r1;tþ1 ; .; rJ;tþ1 ; f0;tþ1  f1t ; f1;tþ1  f2t ; .; fN1;tþ1  fNt
ðL1Þ

for L ¼ J þ N. Notice that conditional on information at date t; ytþ1 wNðmt ; H 0 SS0 HÞ for13
 
H ¼ j1 / jJ b0 / bN1 :
P
Notice further that (1) can be written Wtþ1 ¼ kt þ L[¼1 h[t expðy[;tþ1 Þ for h[t ¼ q[t for [ ¼ 1; .; J and
h[t ¼ z[J;t for [ ¼ J þ 1; .; L. Thus for ht ¼ ðh1t ; .; hLt Þ0 ;

Vart ðWtþ1 Þzh0t H 0 SS0 Hht ! !

PJ P
N
0 P
J P
N
¼ qjt j0j þ znt bn1 SS0 qjt jj þ z[t b[1 :
j¼1 n¼1 j¼1 [¼1

Appendix B. Normalization

Baseline model. Let rQ ¼ r  L; and notice from (10) that

n
bn ¼ rQ 0 b0 : (40)

We will parameterize this in terms of x ¼ ðx1 ; x2 Þ0 where xi denotes an eigenvalue of rQ 0 : We could

calculate the following matrix as a function of those eigenvalues:
" #
x01 x41 x81
KðxÞ ¼ : (41)
ð23Þ x02 x42 x82
The claim is that if we specify

0 0
13
Here mt ¼ ðm1t ; .; mLt Þ0 for m[t ¼ x[ þ j0[ ðc þ rxt Þ for [ ¼ 1, ., J and m[t ¼ a[J1 þ b[J1 ðc þ rxt Þ  a[J  b[J xt for
[ ¼ J þ 1, ., L.
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 33

" #1 " #

Q0 x1 0
r ¼ KðxÞ H10 KðxÞ H10 (42)
ð22Þ ð23Þ ð32Þ 0 x2 ð23Þ ð32Þ

" #1
1
b0 ¼ KðxÞ H10 ; (43)
ð21Þ ð23Þ ð32Þ
1

then (34), the desired condition for bn, would be satisfied. To prove this, observe from (40) that
" #
 1 xn1 0   1 1
bn ¼ KðxÞH10 KðxÞH10 KðxÞH10
0 xn2 1
" #
 1 xn1 ð44Þ
¼ KðxÞH10 n
x2
so that
2 3 2 3
b00 x0 x02 
4 0 5 6 14 7 0 1
H1 b4 ¼ H1 4 x1 x42 5 H1 KðxÞ : (45)
b08 x81 x82
Substituting (41) into (45) produces (34), as claimed. Thus if we know x; we can use (41) and (44) to
calculate the value of bn for any n as well as rQ from (42).
To achieve the separate condition (35) on an ; notice from (11) that
   
an ¼ a0 þ b0n1 þ b0n2 þ / þ b00 cQ þ ð1=2Þ b0n1 SS0 bn1 þ b0n2 SS0 bn2 þ / þ b00 SS0 b0 : (46)

Define

zn ðxÞ ¼ b0n1 þ b0n2 þ / þ b00

ð12Þ
 
jn ðx; a0 ; SÞ ¼ a0 þ ð1=2Þ b0n1 SS0 bn1 þ b0n2 SS0 bn2 þ / þ b00 SS0 b0
ð11Þ

so that (46) can be written

an ¼ zn ðxÞcQ þ jn ðx; a0 ; SÞ
where for n ¼ 0 we have z0 ðxÞ ¼ 0 and j0 ðx; a0 ; SÞ ¼ a0 : We claim that if we choose
2 0 31 0 2 31
z0 ðxÞ 1 j0 ðx; a0 ; SÞ
c Q @ 4
¼  H1 z4 ðxÞ 5 A @ 4
H1 j4 ðx; a0 ; SÞ 5A; (47)
z8 ðxÞ j8 ðx; a0 ; SÞ
then (35) would be satisfied. This is demonstrated as follows:
2 2 3
a0 3 z0 ðxÞcQ þ j0 ðx; a0 ; SÞ
4 5 6 7
H1 a4 ¼ H1 4 z4 ðxÞcQ þ j4 ðx; a0 ; SÞ 5
a8 z8 ðxÞcQ þ j8 ðx; a0 ; SÞ
2 3 2 3
j0 ðx; a0 ; SÞ j0 ðx; a0 ; SÞ
¼ H1 4 j4 ðx; a0 ; SÞ 5 þ H1 4 j4 ðx; a0 ; SÞ 5
j8 ðx; a0 ; SÞ j8 ðx; a0 ; SÞ
¼ 0:
34 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

Thus if we know x; a0, and S; we can use (46) and (47) to calculate the value of an for any n. Also x; a0 ,
and S allow calculation of cQ from (47).
Seasonal model. Just as in the baseline model, we let ðx1 ; x2 Þ denote the ordered eigenvalues of rQ
and write
  1
b0n ¼ xn1 xn2 H1 KðxÞ0
which achieves the normalization (34). Likewise for an we again use (47) where now

zn ðxÞ ¼ b0n1 þ b0n2 þ / þ b00

jn ðx; a0 ; SÞ ¼ a0 þ ð1=2Þ b0n1 SjðnÞ S0jðnÞ bn1 þ b0n2 Sjðn1Þ S0jðn1Þ bn2 þ / þ b00 Sjð1Þ S0jð1Þ b0 :

Appendix C. Mapping from structural to reduced-form parameters

Baseline model. Expressions involving B1j in (23) can be simplified by noting from (40) and (34)
that
2 3 2 0 3
b04j b0
6 0 7 4j 4j
B1j ¼ H1 4 b8j 5 ¼ H1 4 b04 5 rQ ¼ rQ :
b012j b08
Thus for example (27) simplifies to
2 30 2 311
b04j b04j
6 0 7B 6 0 7C
Gj ¼ H 2 6 7B 6 7C
4 b8j 5@H1 4 b8j 5A
b012j b012j
2 0 3
b0 h i
6 7 4j  Q 4j 1 (48)
¼ H2 4 b04 5 rQ r
b0
2 80 3
b0
6 7
¼ H2 4 b04 5 for j ¼ 1; 2; 3; 4:
b08
The population magnitudes corresponding to the other reduced-form OLS coefficients are as follows:

4j 4j
Uj ¼ rQ SS0 rQ 0 for j ¼ 1; 2; 3; 4

3
F1 ¼ rQ r

4j h 1 i4jþ1
Fj ¼ rQ r rQ for j ¼ 2; 3; 4

2 3 2 3 2 3
a3 b03 a0
f1 ¼ H1 a7 þ H1 b07 5c  F1 H1 4 a4 5
4 5 4
a11 b011 a8
 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37 35

2 3 2 2 3 3
a4j b04j a5j
6 0 7
fj ¼ H1 a8j þ H1 4 b8j 5c  Fj H1 a9j 5 for j ¼ 2; 3; 4
4 5 4
a12j b0 a13j
12j

2 3 2 3
a4j a4j
gj ¼ H2 4 a8j 5  Gj H1 4 a8j 5 for j ¼ 1; 2; 3; 4:
a12j a12j
Given the scalars fx1 ; x2 g (corresponding to the eigenvalues of rQ ¼ r  L), we can calculate bn from
(44) and (41). These bn give us predicted values for fGj g4j¼1 ; and the bn along with S give predicted
values for fUj g4j¼1. Note fx1 ; x2 g also gives us rQ ; and this plus r gives predicted values for fFj g4j¼1. From
bn ; S; and a0 we can calculate cQ from (47) and an from (46). Using these along with c we then obtain
the predicted values for ffj g4j¼1 and fgj g4j¼1 .
The information matrix for the OLS estimates p b ¼ ðpb 0F ; p
b 0U ; p
b 0G p
b s Þ0 is given by
2 3
b
R 0 0 0
F
6 b 7
6
bp ¼ 6 0 R U 0 0 7
R
b 7 (49)
4 0 0 R G 0 5
0 0 0 bs
R

2 3
b
R 0 0 0
F1
6 b 7
b 6 0 R F2 0 0 7
RF ¼ 6 7
4 0 0 b
R 0 5
F3
0 0 0 b
R F4

X
T
b ¼ U
R b 1 5T 1 y y0
x1;j;s x1;j;s
Fj j
s¼1

2 3
b
R 0 0 0
U1
6 b 7
6
b ¼ 6 0 RU2 0 0 7
R U b 7
4 0 0 R U3 0 5
0 0 0 b
R U4

 
b ¼ ð1=2ÞD0 U
R b 1 5 U
b 1 D
Uj 2 j j 2

2 3
1 0 0
60 1 07
6
D2 ¼ 4 7
0 1 05
0 0 1

2 3
b
R 0 0 0
G1
6 b 7
b ¼ 6
R 6
0 R G2 0 0 7
7
G 4 0 b
0 R G3 0 5
0 0 0 b
R G4
36 J.D. Hamilton, J.C. Wu / Journal of International Money and Finance 42 (2014) 9–37

!
X
T
b ¼ s
R Gj b 2
ej T 1
y y0
x2;j;s x2;j;s
s¼1

2 4 3
b e1
ð1=2Þ s 0 0 0
6 b 4 7
bs ¼ 6 0 ð1=2Þ s e2 0 0 7
R 6 7
4 0 0 b 4
ð1=2Þ s e3 0 5
4
0 0 0 b e4
ð1=2Þ s

where D2 is the duplication matrix satisfying D2 vechðUÞ ¼ vecðUÞ for 2  2 symmetric matrix U: Note
b ej and
that for all models considered the MCS estimate of sej is always equal to the unconstrained MLE s
so contributes 0 to the weighted objective function.
Unrestricted seasonal model. For this model the specifications for gj and Gj are the same as in the
baseline model, while the expressions for the other parameters become

3 0 3
U1 ¼ r Q S4 S04 rQ

4j 0 4j
Uj ¼ rQ Sj1 S0j1 rQ for j ¼ 2; 3; 4

3
F1 ¼ rQ r4

4j h 1 i4jþ1
Fj ¼ rQ rj1 rQ for j ¼ 2; 3; 4 (50)

2 3 2 3 2 3
a3 b03 a0
f1 ¼ H1 4 a7 5 þ H1 4 b07 5c4  F1 H1 4 a4 5
a11 b011 a8

2 3 2 2 3 3
a4j b04j a5j
6 0 7
fj ¼ H1 4 a8j 5 þ H1 4 b8j 5cj1  Fj H1 4 a9j 5 for j ¼ 2; 3; 4:
a12j b0 a13j
12j

Minimum-chi-square estimation in this case is achieved by first choosing fx; a0 ; S1 ; S2 ; S3 ; S4 g so as

b ;U
bj; G
to minimize the distance from the OLS estimates f g b g4 . From x we can then calculate rQ ; with
j j j¼1
which we can obtain rj analytically from (50) in order to fit these OLS coefficients perfectly. The values
c b:
are likewise obtained analytically from f
j1 j

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