Random Walk or Mean Reversion? Empirical Evidence from the Crude Oil Market

Abstract

The paper investigates and gives an update on the empirical evidence for or against the random walk theory in the crude oil market. The paper investigates whether there are periods when crude oil prices follow the random walk process and periods when they deviate from the random walk theory (mean reverting). Various studies often give conflicting results for the same study period. Some computations conducted over the period of 2000-2005 lead to inconclusive results (Geman, 2007), suggesting that more work remains to be done in this period and beyond. It is imperative to revisit mean reversion and random walk in the context of crude oil as it has serious implication on modeling crude oil prices. In this paper, a Garch model with time-varying properties is applied to capture periods when the random walk theory may be true and periods when it may be false. This study concludes the existence of mean reversion for crude oil price over the period 1980 to 1994 and a random walk as of February 1994 to the end of the study period in 2010. Prior to February 1994 some models, like arima models, might have been valid. Beyond this period, models need to recognize the random walk in crude oil returns. 

Keywords

• Efficient market,Garch,Crude oil price,Random walk theory,Time varying parameters

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