Pricing and hedging of long-term futures and forward contracts by a three-factor model

Kenichiro Shiraya and Akihiko Takahashi

Quantitative Finance, 2012, vol. 12, issue 12, 1811-1826

Abstract: This paper demonstrates the pricing and hedging efficiency of a three-factor stochastic mean reversion Gaussian model of commodity prices using oil and copper futures and forward contracts. The model is estimated using NYMEX WTI (light sweet crude oil) and LME Copper futures prices and is shown to fit the data well. Furthermore, it shows how to hedge based on a three-factor model and confirms that using three different futures contracts to hedge long-term contracts outperforms the traditional parallel hedge based on a single futures position by time series data and simulation. It also finds that the three-factor model outperforms the two-factor version with respect to the replication of actual term structures and that stochastic mean reversion models outperform constant mean reversion models in Out of Sample hedges.

Date: 2012
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DOI: 10.1080/14697680903341780

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