Computing the Market Price of Volatility Risk in the Energy Commodity Markets

32 Pages Posted: 10 Dec 2004 Last revised: 31 Oct 2014

See all articles by James Doran

James Doran

University of New South Wales

Ehud I. Ronn

University of Texas at Austin - Department of Finance

Abstract

In this paper we demonstrate the need for a negative market price of volatility risk to recover the difference between Black-Scholes (1973)/Black (1976) implied volatility and realized term volatility. Initially, using quasi-Monte Carlo simulation, we demonstrate numerically that a negative market price of volatility risk is the key risk premium in explaining the disparity between risk-neutral and statistical volatility in both equity and commodity-energy markets. This is robust to multiple specifications that also incorporate jumps. Next, using futures and options data from natural gas, heating oil and crude oil contracts over a ten year period, we estimate the volatility risk premium and demonstrate that the premium is negative and significant for all three commodities. Additionally, there appear distinct seasonality patterns for natural gas and heating oil, where winter/withdrawal months have higher volatility risk premiums. Computing such a negative market price of volatility risk highlights the importance of volatility risk in understanding priced volatility in these financial markets.

Keywords: Derivatives, volatility, energy, options

JEL Classification: G12, G13, Q4

Suggested Citation

Doran, James and Ronn, Ehud I., Computing the Market Price of Volatility Risk in the Energy Commodity Markets. Journal of Banking and Finance, Vol. 32 (pp. 2541-2552) December 2008, Available at SSRN: https://ssrn.com/abstract=628562

James Doran (Contact Author)

University of New South Wales ( email )

College Rd
Sydney, NSW 2052
Australia

Ehud I. Ronn

University of Texas at Austin - Department of Finance ( email )

Graduate School of Business
Austin, TX 78712
United States
512-471-5853 (Phone)
512-471-5073 (Fax)

Do you have negative results from your research you’d like to share?

Paper statistics

Downloads
2,195
Abstract Views
8,491
Rank
12,868
PlumX Metrics