A note on commodity contingent valuation

Abstract

Practical applicationsCommodity contingent valuation typically involves complex procedures, like limit steps, partial differential equations or approximations. These ad hoc solutions can only be used in the concrete problem for which they are developed. This paper tries to review and clarify stochastic calculus in the commodity contingent valuation context, simplifying formulae and deductions. This approach allows for a relatively simple pricing of all sorts of financial derivatives on commodity prices, avoiding limit steps, partial differential equations and approximations. Moreover, it has been shown how to obtain precise estimators of prices for NYMEX WTI crude oil futures contracts, in a two-factor context. AbstractGiven the complex dynamics of commodity prices, most of the papers on the valuation of commodity contingent claims present ad hoc solutions, which are very complex and sometimes include approximations. This paper shows how well-known techniques and results in stochastic calculus can be used to simplify formulae and deductions. Specifically, we show how to obtain more precise estimators of the parameters in the two-factor model by Schwartz than the approximations given by the author, which tend to overestimate the parameters. These divergences are important in the valuation of commodity contingent claims.