Three-factor commodity forward curve model and its joint P and Q dynamics

Sergiy Ladokhin, Svetlana Borovkova*

*Corresponding author for this work

Research output: Contribution to JournalArticleAcademicpeer-review

Abstract

In this paper, we propose a new framework for modeling commodity forward curves. The proposed model describes the dynamics of fundamental driving factors simultaneously under physical (P) and risk-neutral (Q) probability measures. Our model is an extension of the forward curve model by Borovkova and Geman (2007), into several directions. It is a three-factor model, incorporating the synthetic spot price, based on liquidly traded futures, stochastic level of mean reversion and an analog of the stochastic convenience yield. We develop an innovative calibration mechanism based on the Kalman filtering technique and apply it to a large set of Brent oil futures. Additionally, we investigate properties of the time-dependent market price of risk in oil markets. We apply the proposed modeling framework to derivatives pricing, risk management and counterparty credit risk. Finally, we outline a way of adjusting the proposed model to account for negative oil futures prices observed recently due to coronavirus pandemic.

Original languageEnglish
Article number105418
Pages (from-to)1-15
Number of pages15
JournalEnergy Economics
Volume101
Early online date3 Jul 2021
DOIs
Publication statusPublished - Sept 2021

Bibliographical note

Publisher Copyright:
© 2021 The Authors

Copyright:
Copyright 2021 Elsevier B.V., All rights reserved.

Keywords

  • Brent oil futures
  • Commodity forward curve
  • Derivatives pricing
  • Joint dynamics model
  • Kalman filter
  • Oil futures

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