Three-Factor Commodity Forward Curve Model and Its Joint P and Q Dynamics

41 Pages Posted: 8 Feb 2021

See all articles by Sergiy Ladokhin

Sergiy Ladokhin

VU Amsterdam

Svetlana Borovkova

Vrije Universiteit Amsterdam - Faculty of Economics and Business Administration

Date Written: February 5, 2021

Abstract

In this paper, we propose a new framework for modelling commodity forward curves. The proposed model describes the dynamics of fundamental driving factors simultaneously under physical (P) and risk-neutral (Q) probability measures.

Our model an extension of the forward curve model by Borovkova and Geman (2007), into several directions. It is a three-factor model, incorpo- rating the synthetic spot price, based on liquidly traded futures, stochastic level of mean reversion and an analogue of the stochastic convenience yield. We develop an innovative calibration mechanism based on the Kalman ltering technique and apply it to a large set of Brent oil futures. Addition- ally, we investigate properties of the time-dependent market price of risk in oil markets. We apply the proposed modelling framework to derivatives pricing, risk management and counterparty credit risk. Finally, we outline a way of adjusting the proposed model to account for negative oil futures prices observed recently due to coronavirus pandemic.

Keywords: Commodity forward curve, derivatives pricing, oil futures, joint dynamics model, Kalman filter, Brent oil futures

JEL Classification: C51, C32, G13

Suggested Citation

Ladokhin, Sergiy and Borovkova, Svetlana, Three-Factor Commodity Forward Curve Model and Its Joint P and Q Dynamics (February 5, 2021). Available at SSRN: https://ssrn.com/abstract=3780286 or http://dx.doi.org/10.2139/ssrn.3780286

Sergiy Ladokhin

VU Amsterdam ( email )

De Boelelaan 1105
Amsterdam
Netherlands

Svetlana Borovkova (Contact Author)

Vrije Universiteit Amsterdam - Faculty of Economics and Business Administration ( email )

De Boelelaan 1105
Amsterdam, 1081HV
Netherlands

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