Commodity derivatives pricing with cointegration and stochastic covariances

Mei Choi CHIU, Hoi Ying WONG, Jing ZHAO

Research output: Contribution to journalArticlespeer-review

14 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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