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Conclusion

Commodity Modelling with CARMA Processes

Marcel Prokopczuk

ICMA Centre, Henley Business School

Practical Quantitative Analysis in Commodities

London, 18 June 2010

Marcel Prokopczuk, ICMA Centre 1/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Motivation: Oil Price Development

Dec96 Dec98 Dec00 Dec02 Dec04 Dec06 Dec08

0

50

100

150

U

S

D

p

e

r

B

a

r

r

e

l

Oil Price

Marcel Prokopczuk, ICMA Centre 2/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Motivation: Term Structure of Futures Prices

0 5 10 15 20 25

19

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21

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25

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27

08Jan1997

U

S

D

p

e

r

B

a

r

r

e

l

Maturity [months]

Marcel Prokopczuk, ICMA Centre 3/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Motivation: Term Structure of Futures Prices

0 5 10 15 20 25

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15.5

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18

13May1998

U

S

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p

e

r

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a

r

r

e

l

Maturity [months]

Marcel Prokopczuk, ICMA Centre 4/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Motivation: Term Structure of Futures Prices

0 5 10 15 20 25

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06Jun2001

U

S

D

p

e

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a

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e

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Maturity [months]

Marcel Prokopczuk, ICMA Centre 5/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Motivation: Term Structure of Futures Prices

0 5 10 15 20 25

71

71.5

72

72.5

73

73.5

74

74.5

31May2006

U

S

D

p

e

r

B

a

r

r

e

l

Maturity [months]

Marcel Prokopczuk, ICMA Centre 6/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Motivation: Term Structure of Futures Prices

0 5 10 15 20 25

104

106

108

110

112

114

30Apr2008

U

S

D

p

e

r

B

a

r

r

e

l

Maturity [months]

Marcel Prokopczuk, ICMA Centre 7/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Pricing of Futures Contracts

Futures contracts can be priced by no-arbitrage arguments:

Financial contracts: Cost-of-carry

F

t

(T) = S

t

e

r (Tt)

With storage costs:

F

t

(T) = S

t

e

(r +s)(Tt)

No explanation for backwardation

Inferior empirical performance

Equity futures can show backwardation due to dividends

F

t

(T) = S

t

e

(r q)(Tt)

Marcel Prokopczuk, ICMA Centre 8/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Pricing of Commodity Futures Contracts

Commodities dier from pure nancial assets as they are

hold for consumption or production

Similar to the dividend yield of a stock, the holder of the

commodity receives a convenience yield from holding

stocks of commodities

Kaldor (1939): ... stocks of goods... also have a yield...,

by enabling the producer to lay hands on them the

moment they are wanted, and thus saving the cost and

trouble of ordering frequent deliveries, or waiting for

deliveries.

Marcel Prokopczuk, ICMA Centre 9/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Modelling the Convenience Yield

Convenience yield deterministic function of price:

Brennan/Schwartz (1985)

Brennan (1991)

Poor empirical performance

Stochastic convenience yield:

Gibson/Schwartz (1990)

Schwartz (1997)

Schwartz/Smith (2000)

Cassasus/Collin-Dufresne (2005)

All models assume explicitly or implicitly that the

convenience yield follows an Ornstein-Uhlenbeck process

Marcel Prokopczuk, ICMA Centre 10/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Modelling the Convenience Yield

The assumed Ornstein-Uhlenbeck process is the

continuous limit of an AR(1) process

An analysis of the approximated (net) convenience yield

t,T1,T

= ln

F(t,T)

F(t,T1)

dynamics appropriately

An ARMA(1,1) or higher order AR(q) model yield much

better t to the data

Marcel Prokopczuk, ICMA Centre 11/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Outline

Contribution of this work:

1. Formulation of a commodity pricing model in

continuous time allowing for higher order auto-

regression and moving average components:

ABM-CARMA(p,q)

2. Derivation of closed-form solutions for futures and

options prices

3. Application to the crude oil futures market,

demonstrating the models superior empirical

performance

Marcel Prokopczuk, ICMA Centre 12/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Description: ABM-CARMA(2,1)

Latent factor spot price model in continuous time:

One non-stationary factor Z

t

: long-term equilibrium

modelled by an Arithmetic Brownian Motion

One stationary factor Y

t

: short-term deviations from

the equilibrium modelled by a CARMA(1,0) process

(Schwartz/Smith 2000)

ln S

t

= Z

t

+ Y

t

dZ

t

= dt +

Z

dW

Z

t

dY

t

= kY

t

dt +

Y

dW

Y

t

dW

t

Marcel Prokopczuk, ICMA Centre 13/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Description: ABM-CARMA(2,1)

Latent factor spot price model in continuous time:

One non-stationary factor Z

t

: long-term equilibrium

modelled by an Arithmetic Brownian Motion

One stationary factor Y

t

: short-term deviations from

the equilibrium modelled by a CARMA(2,0) process

xxxxxxxxxxxxxxxxxx

ln S

t

= Z

t

+ Y

t

dZ

t

= dt +

Z

dW

Z

t

d

Y

t

= k

Y

t

dt +

Y

dW

Y

t

dY

t

=

Y

t

dt

Marcel Prokopczuk, ICMA Centre 14/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Description: ABM-CARMA(2,1)

Latent factor spot price model in continuous time:

One non-stationary factor Z

t

: long-term equilibrium

modelled by an Arithmetic Brownian Motion

One stationary factor Y

t

: short-term deviations from

the equilibrium modelled by a CARMA(2,1) process

xxxxxxxxxxxxxxxxxx

ln S

t

= Z

t

+ Y

t

dZ

t

= dt +

Z

dW

Z

t

d

Y

t

= k

Y

t

dt +

Y

dW

Y

t

dY

t

=

Y

t

dt

Marcel Prokopczuk, ICMA Centre 15/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Description: ABM-CARMA(2,1)

Latent factor spot price model in continuous time:

One non-stationary factor Z

t

: long-term equilibrium

modelled by an Arithmetic Brownian Motion

One stationary factor Y

t

: short-term deviations from

the equilibrium modelled by a CARMA(2,1) process

xxxxxxxxxxxxxxxxxx

ln S

t

= Z

t

+ Y

t

+

Y

t

dZ

t

= dt +

Z

dW

Z

t

d

Y

t

= k

Y

t

dt +

Y

dW

Y

t

dY

t

=

Y

t

dt

Marcel Prokopczuk, ICMA Centre 16/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Discussion

Model is formulated directly under the equivalent

martingale measure

Closed form (ane) solutions for the futures price:

ln F(Y

t

,

Y

t

, Z

t

, t; T) = Z

t

+ A

ABM

+ B

Y

t

+ CY

t

+ D

CARMA

Dierence to the standard Schwartz/Smith 2000 model:

Term structure:

Much more exible, especially at the short end

Volatilities:

Non-monotonous structure and higher curvature

Marcel Prokopczuk, ICMA Centre 17/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Factor Loading of

Y

t

B

AR

B

MA

0 2 4 6 8 10

0.0

0.1

0.2

0.3

0.4

B

A

R

0 2 4 6 8 10

0.0

0.2

0.4

0.6

0.8

1.0

B

M

A

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Factor Loading of Y

t

C

AR

C

MA

0 2 4 6 8 10

0.0

0.2

0.4

0.6

0.8

1.0

C

A

R

0 2 4 6 8 10

0.20

0.15

0.10

0.05

0.00

C

M

A

t

,

t

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Entire Futures Curve

0 2 4 6 8 10

2.5

3.0

3.5

Z

t

X

t

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Implementation: Data

Data used:

Crude oil futures traded at the New York Mercantile

Exchange (NYMEX)

Sample period: January 1996 to December 2008

Weekly observations (Wednesday)

Maturities 1 to 24 months

Data source: Bloomberg

Panel data set of 676 x 24 observations

Marcel Prokopczuk, ICMA Centre 21/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Implementation: Kalman Filter Estimation

Implementation of the ABM-CARMA(2,1) model:

Write discretized version in state space form

Dynamics of latent factors: Translation equations

x

t+t

= Gx

t

+c +

t

with

c = t ,

G = e

At

,

E

t

[

t

] = 0 ,

V

t

[

t

] =

t

e

A(tu)

VV

e

A

(tu)

du

Marcel Prokopczuk, ICMA Centre 22/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Model Implementation: Kalman Filter Estimation

Add measurement error to the pricing formula:

Measurement equations

y

t

= d +Hx

t

+

t

with

d = [

(T

1

t) +

1

2

B(t, T

1

), ...,

(T

k

t) +

1

2

B(t, T

k

)]

H = [

A(t, T

1

), ...,

A(t, T

k

)]

E

t

[

t

] = 0

V

t

[

t

] =

Kalman lter maximum likelihood estimation of

parameters

Marcel Prokopczuk, ICMA Centre 23/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

In-Sample Pricing Errors

Benchmark: Schwartz/Smith (2000)

Root Mean Squared Error

Absolute %-Decrease Relative

F01 0.0409 0.0486 15.8% 1.26% 1.49%

F02 0.0283 0.0330 14.2% 0.87% 1.02%

F03 0.0207 0.0230 10.0% 0.64% 0.71%

All 0.0122 0.0141 13.5% 0.38% 0.43%

AIC

ABMCARMA

= 157, 285, AIC

SS2000

= 152, 935,

SIC

ABMCARMA

= 157, 131, SIC

SS2000

= 152, 795.

Marcel Prokopczuk, ICMA Centre 24/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Out-of-Sample Pricing Errors: Time-Series

Split Data Sample into two periods

Estimation: First half

Prediction: Second half

Root Mean Squared Error

Absolute %-Decrease Relative

F01 0.0564 0.0627 10.1% 1.48% 1.59%

F02 0.0510 0.0543 5.9% 1.33% 1.38%

F03 0.0472 0.0488 3.2% 1.23% 1.24%

All 0.0375 0.0381 1.6% 0.94% 0.95%

Marcel Prokopczuk, ICMA Centre 25/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Out-of-Sample Pricing Errors: Cross-Section

Split Data Sample into two parts

Estimation: F01 - F12

Prediction: F13 - F24

Root Mean Squared Error

Absolute %-Decrease Relative

F15 0.0068 0.0090 24.4% 0.21% 0.29%

F18 0.0115 0.0149 22.8% 0.36% 0.48%

F21 0.0173 0.0216 19.9% 0.55% 0.71%

F24 0.0237 0.0284 16.5% 0.75% 0.93%

All 0.0144 0.0179 19.6% 0.46% 0.59%

Marcel Prokopczuk, ICMA Centre 26/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

Conclusion

AR(1) poor description of the convenience yield

Extension of Schwartz/Smith model using continuous time

limit of ARMA processes to describe the convenience yield

Results in:

More exible futures curves

Without the use of additional risk factors

Applied to crude oil futures:

Better t/prediction at the short end

Better prediction of long maturity contracts from short

maturity contracts

Marcel Prokopczuk, ICMA Centre 27/28

1. Introduction 2. ABM-CARMA Model 3. Emprical Model Performance 4. Conclusion

More

Complete paper:

Commodity derivatives valuation with autoregressive and moving

average components in the price dynamics

(with R. Paschke)

forthcoming in Journal of Banking and Finance 2010

More work on commodity modelling:

Marcel Prokopczuk

ICMA Centre - Henley Business School

University of Reading

m.prokopczuk@icmacentre.ac.uk

www.icmacentre.ac.uk/about us/academic sta/dr marcel prokopczuk

Marcel Prokopczuk, ICMA Centre 28/28

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