A change of measure preserving the affine structure in the BNS model for commodity markets

Fred Espen Benth and Salvador Ortiz-Latorre

Papers from arXiv.org

Abstract: For a commodity spot price dynamics given by an Ornstein-Uhlenbeck process with Barndorff-Nielsen and Shephard stochastic volatility, we price forwards using a class of pricing measures that simultaneously allow for change of level and speed in the mean reversion of both the price and the volatility. The risk premium is derived in the case of arithmetic and geometric spot price processes, and it is demonstrated that we can provide flexible shapes that is typically observed in energy markets. In particular, our pricing measure preserves the affine model structure and decomposes into a price and volatility risk premium, and in the geometric spot price model we need to resort to a detailed analysis of a system of Riccati equations, for which we show existence and uniqueness of solution and asymptotic properties that explains the possible risk premium profiles. Among the typical shapes, the risk premium allows for a stochastic change of sign, and can attain positive values in the short end of the forward market and negative in the long end.

Date: 2014-03
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