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Drift matters: An analysis of commodity derivatives

✍ Scribed by Olaf Korn

Publisher: John Wiley and Sons
Year: 2005
Tongue: English
Weight: 213 KB
Volume: 25
Category: Article
ISSN: 0270-7314
DOI: 10.1002/fut.20139

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✦ Synopsis

This article presents a reduced-form, two-factor model to price commodity derivatives, which generalizes the model by Schwartz and Smith (2000). The model allows for two mean-reverting stochastic factors and therefore implies that spot and futures prices can be stationary. An empirical study for the crude oil market tests the new model. Out-of-sample pricing and hedging results for futures and forwards show that the new model dominates the nonstationary model by Schwartz and Smith in the following sense: It works equally well for short-term contracts but leads to major improvements for long-term contracts. This finding is particularly relevant for typical applications like the valuation of commodity-linked real assets with long maturities.

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