Commodity Price Dynamics and Derivative Valuation: A Review

Abstract

This paper reviews extant research on commodity price dynamics and commodity derivative pricing models. In the first half, we provide an overview of key characteristics of commodity price behavior that have been explored and documented in the theoretical and empirical literature. In the second half, we review existing derivative pricing models and discuss how the peculiarities of commodity markets have been integrated in these models. We conclude the paper with a brief outlook on various important research questions that need to be addressed in the future.

The Impact of Cointegration on Commodity Spread Options

“…On the other hand, in the middle panel, depicts the case when Θ is the null matrix and, therefore, the prices are non-stationary and not cointegrated. For example, the residual of the cointegration relation from the previous case, Y 1 …”

“…There is a vast literature on modeling the price of a single commodity as a nonstationary process (see Back and Prokopczuk [1] for a comprehensive recent review). For example, Schwartz and Smith [13] assume the log price of a commodity to be the sum of two latent factors: the long-term equilibrium level, modeled as a geometric Brownian motion, and a short-term deviation from the equilibrium, modeled as a zero mean Ornstein-Uhlenbeck (OU) process.…”