Drift matters: An analysis of commodity derivatives

Olaf Korn

Journal of Futures Markets, 2005, vol. 25, issue 3, 211-241

Abstract: This article presents a reduced‐form, two‐factor model to price commodity derivatives, which generalizes the model by Schwartz and Smith (2000). The model allows for two mean‐reverting stochastic factors and therefore implies that spot and futures prices can be stationary. An empirical study for the crude oil market tests the new model. Out‐of‐sample pricing and hedging results for futures and forwards show that the new model dominates the nonstationary model by Schwartz and Smith in the following sense: It works equally well for short‐term contracts but leads to major improvements for long‐term contracts. This finding is particularly relevant for typical applications like the valuation of commodity‐linked real assets with long maturities. © 2005 Wiley Periodicals, Inc. Jrl Fut Mark 25:211–241, 2005

Date: 2005
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