A multi-factor jump-diffusion model for commodities

John Crosby

Quantitative Finance, 2008, vol. 8, issue 2, 181-200

Abstract: In this paper we develop an arbitrage-free model for the pricing of commodity derivatives. The model generates futures (or forward) commodity prices consistent with any initial term structure. The model is consistent with mean reversion in commodity prices and also generates stochastic convenience yields. Our model is a multi-factor jump-diffusion model, one specification of which allows the prices of long-dated futures contracts to jump by smaller magnitudes than short-dated futures contracts, which, to our knowledge, is a feature that has not previously appeared in the literature, in spite of it being in line with stylised empirical observations (especially for energy-related commodities). Our model also allows for stochastic interest rates. The model produces semi-analytic solutions for standard European options, which enable option prices to be evaluated in typically about 1/50th of a second (depending upon parameter values and the required accuracy). This opens the possibility to calibrate the model parameters by deriving implied parameters from the market prices of options. We perform such a calibration on crude oil options and show that, allowing long-dated futures contracts to jump by smaller magnitudes than short-dated contracts, gives a greatly enhanced fit.

Keywords: Commodity options; Commodity derivatives; Jump diffusion; Mean reversion (search for similar items in EconPapers)
Date: 2008
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (13)

Downloads: (external link)
http://www.tandfonline.com/doi/abs/10.1080/14697680701253021 (text/html)
Access to full text is restricted to subscribers.

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:taf:quantf:v:8:y:2008:i:2:p:181-200

Ordering information: This journal article can be ordered from
http://www.tandfonline.com/pricing/journal/RQUF20

DOI: 10.1080/14697680701253021

Access Statistics for this article

Quantitative Finance is currently edited by Michael Dempster and Jim Gatheral

More articles in Quantitative Finance from Taylor & Francis Journals
Bibliographic data for series maintained by Chris Longhurst ().