A Two Factor Forward Curve Model with Stochastic Volatility for Commodity Prices

Mark Higgins

Papers from arXiv.org

Abstract: We describe a model for evolving commodity forward prices that incorporates three important dynamics which appear in many commodity markets: mean reversion in spot prices and the resulting Samuelson effect on volatility term structure, decorrelation of moves in different points on the forward curve, and implied volatility skew and smile. This model is a "forward curve model" - it describes the stochastic evolution of forward prices - rather than a "spot model" that models the evolution of the spot commodity price. Two Brownian motions drive moves across the forward curve, with a third Heston-like stochastic volatility process scaling instantaneous volatilities of all forward prices. In addition to an efficient numerical scheme for calculating European vanilla and early-exercise option prices, we describe an algorithm for Monte Carlo-based pricing of more generic derivative payoffs which involves an efficient approximation for the risk neutral drift that avoids having to simulate drifts for every forward settlement date required for pricing.

Date: 2017-08, Revised 2017-08
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
http://arxiv.org/pdf/1708.01665 Latest version (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:arx:papers:1708.01665

Access Statistics for this paper

More papers in Papers from arXiv.org
Bibliographic data for series maintained by arXiv administrators ().