Commodity derivatives pricing with cointegration and stochastic covariances

Mei Choi CHIU, Hoi Ying WONG, Jing ZHAO

Research output: Contribution to journalArticles

11 Citations (Scopus)

Abstract

Empirically, cointegration and stochastic covariances, including stochastic volatilities, are statistically significant for commodity prices and energy products. To capture such market phenomena, we develop a continuous-time dynamics of cointegrated assets with a stochastic covariance matrix and derive the joint characteristic function of asset returns in closed-form. The proposed model offers an endogenous explanation for the stochastic mean-reverting convenience yield. The time series of spot and futures prices of WTI crude oil and gasoline shows cointegration relationship under both physical and risk-neutral measures. The proposed model also allows us to fit the observed term structure of futures prices and calibrate the market-implied cointegration relationship. We apply it to value options on a single commodity and on multiple commodities. Copyright © 2015 Elsevier B.V. and Association of European Operational Research Societies (EURO) within the International Federation of Operational Research Societies (IFORS).
Original languageEnglish
Pages (from-to)476-486
JournalEuropean Journal of Operational Research
Volume246
Issue number2
Early online dateMay 2015
DOIs
Publication statusPublished - 2015

Citation

Chiu, M. C., Wong, H. Y., & Zhao, J. (2015). Commodity derivatives pricing with cointegration and stochastic covariances. European Journal of Operational Research, 246(2), 476-486.

Keywords

  • Stochastic convenience yield
  • Option pricing
  • Cointegration
  • Stochastic covariance

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