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= +
(2)
where
0
y is baseline,
0
R is the center of the peak, A is the total areas under the curve from the baseline, and w
is equal to the width of the peak at half height. The fitted probability distributions and corresponding parameters of the
daily returns for the crude oil market is shown in Figures 4 and Table 3.
Figure 4: The fitted probability distribution of daily return for entire trading time
for West Texas Intermediate crude oil market
Table 3: The parameters of daily returns fitted by the Gaussian function
a,b
Parameters Crude oil market
Mean() 0.0244
Standard Dev.() 0.0290
Center(
0
R )
-0.0028
Width( w ) 0.0323
Height( h )
21.983
a. We use the Gaussian function to fit the original distribution. The Gaussian function is
2
0
2
2( )
0
( )
/ 2
R R
w
A
f R y e
w t
= +
, where
0
y is the
baseline,
0
R is the center of the peak, w is equal to the width of the peak at half height, and h is the height of the fitted distribution.
b. The sample covers the period from January 1, 1986 through December 31, 2007 for a total of 5,405 observations.
Figure 4 shows the probability distribution of the daily returns for the crude oil market with a peak at -0.0002.
Here, the peak means the location of the highest probability of daily returns, and it also represents daily returns in crude
oil market are more central at 0. Table 3 shows the parameters of daily returns fitted by the Gaussian function. The
crude oil market has a negative center at -0.0028. In addition, the width of the crude oil market is 0.0323. This evidence
4
Assuming the returns to be uncorrelated, the standard deviation for the mean equals the standard deviation divided by the root of the sample size.
(Andersen and Bollerslev, 1997)
5
Gaussian function is characteristic symmetric bell sharp curve that quickly falls off towards plus/ minus infinty. The parameter of Gaussian function
is the height of the curves peak, the position of the center of the peak, and the width of the bell.
is rational and consistent; it shows that crude oil market is more volatile and easy to be shocked by imbalance of supply
and demand, policies adopted by the OPEC, political tensions in the Middle East and so on. This finding is in agreement
with Regnier (2007) showing that since the 1973 oil crisis, crude oil prices have been more volatile than other
commodities and Yang et al., (2002) that given the 4% cut in OPEC production, the crude oil prices are expected to
increase unless the recession is serve, Rigobon and Sack (2005) found evidence that oil prices are affected by conflict
(war) risk, and Lee and Cheng (2007) demonstrated that the volatility of crude oil is of significantly high levels during
periods of the Gulf War.
MEASURE VOLATILITY AND THE PROBABILITY DISTRIBUTION OF VOLATILITY
To explicitly display the distribution of the daily return volatility, this section builds the probability distributions
corresponding to the entire trading time of daily return volatility.
Quantify Volatility
This study estimates volatility as the local average of absolute price changes over a proper time interval T.
Generally, T is an adjustable parameter, but this study takes 5 T = days
6
for constructing the time series of volatility.
The volatility ( ) V t is defined as the average of absolute value of ( ) G t over a time window 5 T t o = ,
( ) ( )
4
0
1
5
n
V t G t n t o
=
= +
(3)
Figure 5 shows the calculated time series of volatility for the crude oil market. It is a volatile market with a
highest mean (at 0.0178) and standard deviation (at 0.0138). Crude oil prices volatility, associated with bouts of
inflation and economic instability over the last twenty years, its volatility fluctuates most dramatically over the daily
cycle. It reveals a pronounced difference in the volatility over the day, ranging from a low of around 0.0006 to a high of
around 0.1798. This pattern is closely linked to the market activity in the various financial centers around the globe.
Guo and Kliesen (2005) indicated that unanticipated economic developments could roil crude oil markets and increase
volatility, and the decline in the trade-weighted value of the US dollar. Another cause of increased uncertainty could
reflect exogenous events that are noneconomic in nature, such as the strategies of the OPEC or political instabilities in
the Middle East. Lee and Cheng (2007) the prices of crude oil are often subject to variables of supply, demand,
production economics, environmental regulations and other factors.
.00
.01
.02
.03
.04
.05
.06
.07
.08
86 88 90 92 94 96 98 00 02 04 06
Figure 5: The time series of volatility for the crude oil market
Probability Distribution of Volatility
To display the distribution of volatility more clearly, we will construct the probability distributions for the time
series of volatility. The resultant distributions for the sample markets are observed to have long tails and be
asymmetrical across the peak of the curve. The log-normal distribution can take characteristics into consideration, and
thus the log-normal distribution function is used to fit the data. To construct the probability distribution of volatility, this
6
Since the absolute value of daily return during a week with 5 observations, we set a time window which is equal to 5; therefore, the daily volatility
is defined as the average absolute value of the daily return over a time window 5 T t o = .
study uses the histogram method to count the value of volatility ( )
n
N V for the volatility ranging between
( )
n
V n V = A and
1
( 1)( )
n
V n V
+
= + A . Here, n is an integer ranging between 0 and . The probability of volatility
in the interval between
n
V and
1 n
V
+
is then given as Equation (4), with the normalization as Equation (5).
( )
( )
( )
0
n
n
n
m
N V
P V V
N V
=
A =
(4)
( )
0
1
n
n
P V V
=
A =
(5)
Figure 6: The probability distribution function as a function of volatility for the sample market
Table 4: Summary statistic of the volatility of daily returns for crude oil market
a
Crude oil market
Mean 0.0178**
(0.0000)
Max 0.1798
Min 0.000645
Standard Dev. 0.0138
Skewness
b
4.1299**
(0.0000)
Kurtosis
b
31.0909**
(0.0000)
Jarque-Bera
c
232845.89**
(0.0000)
a. The table summaries the distribution of the daily volatilities for the crude West Texas Intermediate oil market. Market volatility is estimated using
average local price changes. The sample covers the period from January 1, 1986 through December 31, 2007, for a total of 5,405 observations.
b. Under the null hypothesis of independent, identically distributed normally distributed returns, the sample Skewness and Kurtosis are asymptotically
normal with means of 0 and 3.
c. Jarque-Bera is Jarque-Bera test statistic, distributed
2
2
_ .
d. ** denotes significance at 0.05.
Figure 6 represents the result of probability distribution of volatility. First, the distribution is asymmetric with the
peak, and second, the distributions have longer tails than the normal distribution. The results are consistent with earlier
work by Yu and Huang (2004), and Yu et al. (2008). From the distributions shown in Figure 6, some descriptive
statistics for the sample markets are listed in Table 4. The average volatility of crude oil market is 0.0178 with a
standard deviation of 0.0138. The distribution is right-skewed (with a Skewness of 4.1299) and lepto-kurtosis
distribution (with a Kurtosis of 31.0909). It shows that the typical non-normality of financial time series.
( )
( )
2
1/ 2 2
1 1
exp ln
2
2
c
V
P V
w V
wV t
(
| |
( =
|
(
\ .
(6)
( )
0
1 P V dV
=
}
(7)
Yu et al. (2008), and Yu and Huang (2004) suggest that the log-normal distribution may capture features.
According to their methodology, we adopt the log-normal function P(V) and the function contains two parameters, the
first Vc represents the scale parameter, the secondrepresents distribution width. The corresponding values of the two
parameters are listed in Table 5. It not only shows the highest probability and the width of the distribution, but also
shows the average volatility, indicating the whole volatility, and the standard deviations, indicating the fluctuations in
volatility.
Table 5: The parameters of volatility of log-normal function for the crude oil market
Crude oil market
Mean 0.0178
Standard Dev. 0.0138
Peak Probability
a
0.0147
Dis. Width
a
0.5999
Volatility Area w V
c
-0.5852~0.6146
a. The equation (6) contains two parameters, the first is peak probability represents the peak probability location, and the second is distribution width
the represents distribution width.
( )
( )
2
1/ 2 2
1 1
exp ln
2
2
c
V
P V
w V
wV t
(
| |
( =
|
(
\ .
From Table 5, as for the crude oil market, it possesses the peak probability and peak width, at 0.0147 and 0.5999,
respectively. Meanwhile, given that the range of w V
c
represents typical volatility conditions in sampling market,
the volatility area in crude oil market is -0.5852~0.6146.
CONCLUSIONS
Crude oil is not only the worlds most actively traded commodity, but also the largest volume of futures trading of
a physical commodity in the world. This article is different from the existing works; we apply time series techniques to
detect commodities markets to find out the statistical properties of daily returns and volatility. In this article, we offer a
comprehensive study of the daily returns and volatility process for universally recognized and widely traded physical
assets: crude oil market. Using probability distribution techniques, this paper explores whether any probability
distribution differences exist in returns and volatility of crude oil market. This can avoid potential biases resulting from
only seeing the mean, standard deviation of returns and neglecting the other parameters of the distribution (the peak and
width of the distribution, the volatility area for the sampling market). And we can get more information about the
investors' behaviors.
All these findings are important to market traders and hedging strategies, these have important implications for
international investors, multinational firms, and risk managers and so on. They consider the impact of commodity return
and volatility on portfolio diversification and on management, risk assessment, pricing and hedging, asset allocation
decisions.
After fitting the distributions and estimating the parameters of the Gaussian distribution for daily returns, we find
that the average return for crude oil market is 0.0244, with a standard deviation of 0.0290. The distribution is slightly
left-skewed (with a skewness of -0.0115) and lepto-kurtosis (with a kurtosis of 37.9153). This evidence is rational and
consistent with Lee and Cheng, 2007; Choi and Hammoudeh, 2009. After estimating the peak and width of the volatility
for the log-normal distribution, the crude oil market is a unstable and volatile market. This evidence is rational and
consistent with Regnier, 2007; Yang et al., 2002; Rigobon and Sack, 2005; Lee and Cheng, 2007; Guo and Kliesen,
2005; because crude oil market is more volatile and easy to be shocked by the imbalance of supply and demand, the
policies adopted by the OPEC, the political tensions in Middle East and so on.
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