Correlation Structure between Inflation and Oil Futures Returns: An Equilibrium Approach
Jaime Casassus; Diego Ceballos; Freddy Higuera
Documento de Trabajo IE-PUC, Nº 373, 2010.
Abstract: We use an equilibrium model of a monetary economy to understand the economics behind the correlation between inflation and oil futures returns. We nd that some of the positive correlation found in empirical studies is due to the fact that oil is in the consumption basket, however, this accounts only for a minor part of it. There exist other important sources of correlation related to monetary shocks and output shocks. In particular, we nd that the correlation is extremely sensitive to the reaction of the central bank to output shocks, while the reaction to inflation changes is lesssigni cant. We estimate our model using maximum likelihood with the following datasets: crude oilfutures prices, nominal interest rates, inflation rates and money supply growth rates. Our estimates suggest that the monetary authority overreacts to output shocks by increasing the money supply in a more than necessary amount, generating a signi cant source of positive correlation. From a practical perspective, We nd that it is a good strategy to use as a hedge, the futures whose maturity is closer to the hedging horizon. This is particularly true for short-term hedging.
Keywords: Correlation structure, inflation, futures, hedging, oil, monetary policy
JEL: E31, G13, Q31, E44, E52, E23, D51.