Calibrating Market Model to Commodity and Interest Rate Risk

Patrik Karlsson, Kay F Pilz and Erik Schlogl
Additional contact information
Patrik Karlsson: Quantitative Analytics, ING Bank
Kay F Pilz: RIVACON GmbH

No 372, Research Paper Series from Quantitative Finance Research Centre, University of Technology, Sydney

Abstract: Based on the multi-currency LIBOR Market Model (LMM) this paper constructs a hybrid commodity interest rate market model with a time-dependent stochastic local volatility function allowing the model to simultaneously fit the implied volatility surfaces of commodity and interest rate options. Since liquid market prices are only available for options on commodity futures, rather than forwards, a convexity correction formula for the model is derived to account for the difference between forward and futures prices. A procedure for efficiently calibrating the model to interest rate and commodity volatility smiles is constructed. Finally, the model is fitted to an exogenously given correlation structure between forward interest rates and commodity prices (cross–correlation). When calibrating to options on forwards (rather than futures), the fitting of cross–correlation preserves the (separate) calibration in the two markets (interest rate and commodity options), while in the case of futures a (rapidly converging) iterative fitting procedure is presented. The fitting of cross–correlation is reduced to finding an optimal rotation of volatility vectors, which is shown to be an appropriately modified version of the “orthonormal Procrustes” problem in linear algebra. The calibration approach is demonstrated in an application to market data for oil futures.

Keywords: Calibration; Commodity markets; Derivative pricing; Interest rate modelling; Interest rate derivatives; Oil futures; Energy derivatives (search for similar items in EconPapers)
Pages: 26 pages
Date: 2016-05-01
New Economics Papers: this item is included in nep-ene
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Citations: View citations in EconPapers (3)

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