Pricing of Long-Dated Commodity Derivatives: Do Stochastic Interest Rates Matter?

Abstract

Does modelling stochastic interest rates, beyond stochastic volatility, improve pricing performance
on long-dated commodity derivatives? To answer this question, we consider futures
price models for commodity derivatives that allow for stochastic volatility and stochastic interest
rates and a correlation structure between the underlying variables. We examine the empirical pricing performance of these models on pricing long-dated crude oil derivatives. Estimating the model parameters from historical crude oil futures prices and option prices, we find that stochastic interest rate models improve pricing performance on long-dated crude oil derivatives, when the interest rate volatility is relatively high. Furthermore, increasing the model dimensionality does not tend to improve the pricing performance on long-dated crude oil option prices, but it matters for long-dated futures prices. We also find empirical evidence for a negative correlation between crude oil futures prices and interest rates that contributes to improving t to long-dated crude oil option prices.

Keywords: Futures options pricing, Stochastic interest rates, Correlations, Long-dated crude oil derivatives, commodity futures

JEL Classification: C13, C60, G13, Q40