Pricing Commodity Futures Options in the Schwartz Multi Factor Model with Stochastic Volatility: An Asymptotic Method

23 Pages Posted: 14 Nov 2016

See all articles by Jilong Chen

Jilong Chen

University of Glasgow - Adam Smith Business School

Christian Oliver Ewald

University of Glasgow; Høgskole i Innlandet

Date Written: November 14, 2016

Abstract

In this paper we investigate the applicability of the asymptotic approach developed in Fouque et al. (2000) for pricing commodity futures options in a Schwartz (1997) multi factor model, featuring both stochastic convenience yield and stochastic volatility. We show that the zero order term in the expansion coincides with the Schwartz (1997) two factor term, with expected long-term volatility replacing the constant volatility term, and provide an explicit expression for the first order correction term. Using empirical data from the natural gas futures market, we demonstrate that a significantly better calibration can be achieved by involving the correction term as compared to the standard Schwartz (1997) two factor expression. This improvement comes at virtually no extra effort.

Keywords: Commodities; Derivatives; Stochastic Volatility; Stochastic Convenience Yield

JEL Classification: G11

Suggested Citation

Chen, Jilong and Ewald, Christian Oliver, Pricing Commodity Futures Options in the Schwartz Multi Factor Model with Stochastic Volatility: An Asymptotic Method (November 14, 2016). Available at SSRN: https://ssrn.com/abstract=2869041 or http://dx.doi.org/10.2139/ssrn.2869041

Jilong Chen

University of Glasgow - Adam Smith Business School ( email )

Glasgow, Scotland
United Kingdom

Christian Oliver Ewald (Contact Author)

University of Glasgow ( email )

Adam Smith Building
Glasgow, Scotland G12 8RT
United Kingdom

Høgskole i Innlandet ( email )

Lillehammer, 2624
Norway

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