Pricing Commodity Futures Options in the Schwartz Multi Factor Model with Stochastic Volatility: An Asymptotic Method
23 Pages Posted: 14 Nov 2016
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: Suggested Citation