Commodity derivatives pricing with cointegration and stochastic covariances

Mei Choi Chiu, Hoi Ying Wong and Jing Zhao

European Journal of Operational Research, 2015, vol. 246, issue 2, 476-486

Abstract: Empirically, cointegration and stochastic covariances, including stochastic volatilities, are statistically significant for commodity prices and energy products. To capture such market phenomena, we develop a continuous-time dynamics of cointegrated assets with a stochastic covariance matrix and derive the joint characteristic function of asset returns in closed-form. The proposed model offers an endogenous explanation for the stochastic mean-reverting convenience yield. The time series of spot and futures prices of WTI crude oil and gasoline shows cointegration relationship under both physical and risk-neutral measures. The proposed model also allows us to fit the observed term structure of futures prices and calibrate the market-implied cointegration relationship. We apply it to value options on a single commodity and on multiple commodities.

Keywords: Option pricing; Cointegration; Stochastic covariance; Stochastic convenience yield (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (12)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ejores:v:246:y:2015:i:2:p:476-486

DOI: 10.1016/j.ejor.2015.05.012

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