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A two-factor cointegrated commodity price model with an application to spread option pricing

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  • Farkas, Walter
  • Gourier, Elise
  • Huitema, Robert
  • Necula, Ciprian

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.

Suggested Citation

  • Farkas, Walter & Gourier, Elise & Huitema, Robert & Necula, Ciprian, 2017. "A two-factor cointegrated commodity price model with an application to spread option pricing," Journal of Banking & Finance, Elsevier, vol. 77(C), pages 249-268.
  • Handle: RePEc:eee:jbfina:v:77:y:2017:i:c:p:249-268
    DOI: 10.1016/j.jbankfin.2017.01.007
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    Keywords

    Commodities; Cointegration; Futures; Option pricing; Spread options; Spark spread; Crack spread;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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