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A Two-Factor Cointegrated Commodity Price Model with an Application to Spread Option Pricing

41 Pages Posted: 25 Oct 2015 Last revised: 26 Jan 2017

Walter Farkas

University of Zurich, Swiss Finance Institute (SFI) at Department of Banking and Finance; ETH Zürich - Department of Mathematics; Swiss Finance Institute

Elise Gourier

Queen Mary, University of London

Robert Huitema

University of Zurich - Department of Banking and Finance

Ciprian Necula

University of Zurich - Department of Banking and Finance; Bucharest University of Economic Studies, Department of Money and Banking

Date Written: November 9, 2016

Abstract

In this paper, we propose an easy-to-use yet comprehensive model for a system of cointegrated commodity prices. While retaining the exponential affine structure of previous approaches, our model allows for an arbitrary number of cointegration relationships. We show that the cointegration component allows capturing well-known features of commodity prices, i.e., upward sloping (contango) and downward sloping (backwardation) term-structures, smaller volatilities for longer maturities and an upward sloping correlation term structure. The model is calibrated to futures price data of ten commodities. The results provide compelling evidence of cointegration in the data. Implications for the prices of futures and options written on common commodity spreads (e.g., spark spread and crack spread) are thoroughly investigated.

Keywords: Commodities, Cointegration, Futures, Option Pricing, Spread Options, Spark Spread, Crack Spread

JEL Classification: C61, G11, G12

Suggested Citation

Farkas, Walter and Gourier, Elise and Huitema, Robert and Necula, Ciprian, A Two-Factor Cointegrated Commodity Price Model with an Application to Spread Option Pricing (November 9, 2016). Journal of Banking and Finance, Forthcoming; Swiss Finance Institute Research Paper No. 15-54. Available at SSRN: https://ssrn.com/abstract=2679218 or http://dx.doi.org/10.2139/ssrn.2679218

Walter Farkas (Contact Author)

University of Zurich, Swiss Finance Institute (SFI) at Department of Banking and Finance ( email )

Plattenstrasse 14
CH-8032 Zurich, Zurich 8032
Switzerland
+41-44-634 3953 (Phone)
+41-44-634 4345 (Fax)

HOME PAGE: http://https://people.math.ethz.ch/~farkas/

ETH Zürich - Department of Mathematics ( email )

ETH Zentrum HG-F 42.1
Raemistr. 101
CH-8092 Zurich, 8092
Switzerland

HOME PAGE: http://https://people.math.ethz.ch/~farkas/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Elise Gourier

Queen Mary, University of London ( email )

Mile End Road
London, E1 4NS
United Kingdom

HOME PAGE: http://www.elisegourier.com

Robert Huitema

University of Zurich - Department of Banking and Finance ( email )

Schönberggasse 1
Zürich, 8001
Switzerland

Ciprian Necula

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 14
Zürich, 8032
Switzerland

Bucharest University of Economic Studies, Department of Money and Banking ( email )

6, Romana Square, District 1
Bucharest, 010374
Romania

HOME PAGE: http://www.dofin.ase.ro/cipnec

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