A two-factor cointegrated commodity price model with an application to spread option pricing |
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| Institution: | 1. University of Zurich, Department of Banking and Finance, Plattenstrasse 14, 8032 Zurich, Switzerland;2. ETH Zurich, Department of Mathematics, Rämistrasse 101, 8092 Zurich, Switzerland, Zurich, Switzerland;3. Swiss Finance Institute, Zurich, Switzerland;4. Queen Mary University of London and CEPR, Mile End Road, London E1 4NS, UK;5. Bucharest University of Economic Studies, Department of Money and Banking, Bucharest, Romania;1. Leibniz University Hannover, Koenigsworther Platz 1, D-30167 Hannover, Germany;2. ICMA Centre, Henley Business School, University of Reading, RG6 6BA, UK;3. Norwich Business School, University of East Anglia, Norwich NR4 7TJ, United Kingdom |
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| 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. |
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