Default return spread: A powerful predictor of crude oil price returns

Abstract

AbstractThis paper uses the default return spread (DFR) to predict crude oil price returns over the period January 1986 through December 2020. Results of in‐sample and out‐of‐sample analyses show that the DFR can predict oil price returns and significantly outperform the benchmark and other competing variables. In an asset allocation exercise, a mean–variance investor can obtain considerable certainty equivalent return (CER) gains based on the return forecasts of DFR relative to the benchmark. We also perform a series of robustness tests to confirm our previous conclusion. We further investigate the source of the DFR's predictive ability from oil market sentiment, in which we provide some theoretical basis to explain.