The Challenges of Negative Oil Future Price Posed to Risk Managers and Quants

The oil future’s precipitous drop to the negative range on April 20, 2020 stunned and confounded many industry professionals and academics. It also posed a great challenge to risk managers and financial engineers responsible for the appropriate models for pricing and risk measurement. This chapter provides an extensive discussion about the rationale and mechanism behind the negative price as well as the related modeling issues. We generalized the situations and scenarios under which negative prices are economically reasonable; examples from past experiences in different markets in the world were discussed. Model choice in handling negative commodity price was discussed. Our analysis and simulation cast doubts on the appropriateness of the Bachelier option model the Chicago Mercantile Exchange (CME) hastily switched to before the big plunge. Specifically, we introduced the hyperbolic sine transformation method, whose output is amenable to the Vascecik model, as a viable alternative to the Bachelier model, and demonstrated its applicability in modeling negative oil price.