Drift Matters: An Analysis of Commodity Derivatives
38 Pages Posted: 12 Aug 2002
Date Written: May 2002
This paper presents a reduced form affine two-factor model to price commodity derivatives, which generalizes the model by Schwartz & 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 & 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.
Keywords: Commodities, Futures, Forwards, Pricing, Hedging
JEL Classification: G13
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