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On the Pricing of Storable Commodities

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  • Dorje C. Brody
  • Lane P. Hughston
  • Xun Yang

Abstract

This paper introduces an information-based model for the pricing of storable commodities such as crude oil and natural gas. The model makes use of the concept of market information about future supply and demand as a basis for valuation. Physical ownership of a commodity is regarded as providing a stream of "convenience dividends" equivalent to a continuous cash flow. The market filtration is assumed to be generated jointly by (i) current and past levels of the dividend rate, and (ii) partial information concerning the future of the dividend flow. The price of a commodity is given by the expectation of the totality of the discounted risk-adjusted future convenience dividend, conditional on the information provided by the market filtration. In the situation where the dividend rate is modelled by an Ornstein-Uhlenbeck process, the prices of options on commodities can be derived in closed form, both in the case when underlying is the spot price, and in the case when underlying is a futures price. The approach presented can be applied to other assets that can yield potentially negative effective cash flows, such as real estate, factories, refineries, mines, and power generating plants.

Suggested Citation

  • Dorje C. Brody & Lane P. Hughston & Xun Yang, 2013. "On the Pricing of Storable Commodities," Papers 1307.5540, arXiv.org.
  • Handle: RePEc:arx:papers:1307.5540
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