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Dorje C. Brody

Department of Mathematics,

Imperial College London,

London SW7 2AZ

www.imperial.ac.uk/people/d.brody

-1-

-2 -

18 June 2010

We consider the valuation of a storable commodity.

Alternatively, we may think of the valuation of a real estate.

We shall be speaking in terms of commodity prices, although the same

construction applies as well to real estate prices.

Let us assume that one unit of the commodity provides a convenience benefit

equivalent to a cash flow {Xt}t0.

Note that we work directly with the actual flow of convenience from the storage

or possession of the commodity, rather than the convenience yield.

The point is that the convenience yield is a secondary notion since it depends on

the price, which is what we are trying to determine.

Thus when a storable commodity is consumed, one can think of it as being

exchanged for a consumption good of identical value.

Think of the difference between a corked bottle of wine (of known quality) and

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-3 -

18 June 2010

The consumption good in the latter example is not storable, and must be

consumed immediately.

The value of the commodity is then given in the risk-neutral measure by:

1 Q

PuXudu ,

S t = Et

Pt

t

where

(1)

Pu = exp

rsds

(2)

We shall write Et[] = EQ[|Ft] for the expectation in the risk-neutral measure

conditional on the information flow {Ft}.

For simplicity, let us now assume that the interest rate system is deterministic.

Once we work things out for deterministic rate {rt} then we can consider the

general situation.

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-4 -

18 June 2010

We shall assume that the market filtration is generated jointly by the following

processes:

(a) an information process {t}t0, given by

t = t

PuXudu + Bt,

(3)

(b) the commodity convenience benefit flow process {Xt}t0.

Thus, at time t we have

Ft = {s}0st, {Xs}0st .

(4)

benefit flow up to time t and the noisy information of the future benefit flow.

Modelling the convenience benefit process

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-5 -

18 June 2010

As a simple model for the commodity convenience benefit, let us consider the

case where {Xt} is given by an Ornstein-Uhlenbeck (OU) process.

Then we have

dXt = ( Xt)dt + dt,

where {t} is a Brownian motion that is independent of {Bt}.

(5)

Here is the mean reversion level, is the mean reversion rate, and is the

volatility.

We shall be looking at the constant parameter case first, and then extend the

results into time-dependent situation.

A standard calculation making use of an integration factor shows that

Xt = e

X0 + (1 e

) + e

esds.

(6)

Thus, starting from the initial value X0, the process tends in mean towards the

level , and has the variance

2

Var[Xt] =

1 e2t

(7)

2

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-6 -

18 June 2010

2 T t

e

e et .

Cov[Xt, XT ] =

2

(8)

In what follows we need some further properties of the OU process.

A short calculation establishes that for T > t we have

XT = e(T t)Xt + (1 e(T t)) + eT

eudu.

(9)

Furthermore, by use of the variance-covariance relations one can easily verify

that Xt is independent from XT e(T t)Xt.

This independence relation illustrates the Markov property of the OU process.

This property corresponds to an orthogonal decomposition of the form

XT = (XT e(T t)Xt) + e(T t)Xt

Practical Quantitative Analysis in Commodities

(10)

c DC Brody 2010

-7 -

18 June 2010

for T > t.

Interestingly, there is another orthogonal decomposition as well, this time for Xt,

which plays a crucial role in what follows.

This decomposition is given by

Xt =

et et

XT

Xt T

e eT

et et

XT .

+ T

e eT

(11)

et et

btT = Xt T

XT

T

e e

is an Ornstein-Uhlenbeck bridge (OU bridge).

An alternative way of expressing the OU bridge is to write

sinh(t)

btT = Xt

XT .

sinh(T )

Clearly we have b0T = X0 and bT T = 0.

Practical Quantitative Analysis in Commodities

(12)

(13)

c DC Brody 2010

-8 -

18 June 2010

sinh(t) + sinh((T t))

sinh((T t))

X0 + 1

E[btT ] =

sinh(T )

sinh(T )

and variance

2 cosh(T ) cosh((T 2t))

var[btT ] =

.

2

sinh(T )

The mean and variance of the OU bridge are plotted in Figure 1.

(14)

(15)

Armed with these facts, now we shall show that

E

t

PuXudu t, Xt . (16)

First we note that

Ft = {s}0st, {Xs}0st

= {s}0st, {Xs}0st ,

Practical Quantitative Analysis in Commodities

(17)

c DC Brody 2010

-9 -

18 June 2010

OU Bridge

0.7

data1

data2

Mean

Variance

0.6

0.5

0.4

0.3

0.2

0.1

-0.1

-0.2

50

100

150

200

250

300

350

Time

Mean (red) and variance (blue) of the OU bridge. The parameters are set as = 0.15, T = 1, X0 = 0.6,

= 1.4, and = 0.5.

Figure 1:

c DC Brody 2010

-10 -

where

t = t

18 June 2010

PuXudu + Bt.

(18)

t

t = t t

PuXudu.

(19)

t s

Ft = t,

t

s

0<st

, {Xs}0st .

(20)

t s

Q [T < x|{s}0st] = Q T < x t,

t

s

= Q [T < x|t] .

0<st

(21)

This follows from the fact that t and T are independent from Gt, where

t s

Gt =

,

t

s 0st

which follows in turn from properties of the standard Brownian motion.

Practical Quantitative Analysis in Commodities

(22)

c DC Brody 2010

-11 -

18 June 2010

We note first that

t s Bt Bs

=

.

(23)

t

s

t

s

Now it is a property of Brownian motion that for any times t, s, s1 satisfying

t > s > s1 > 0 the random variables Bt and Bs/s Bs1 /s1 are independent.

More generally, if s > s1 > s2 > s3 > 0, we find that Bs/s Bs1 /s1 and

Bs2 /s2 Bs3 /s3 are independent.

It follows that t and T are independent from Gt.

We remark, furthermore, that Xs is independent of Gt.

c DC Brody 2010

-12 -

18 June 2010

Pt St = E

t

= E

t

= E

t

PuXudu Ft

PuXudu t, Gt, {Xs}0st

PuXudu t, {Xs}0st

PuXudu t, {Xs}0st .

(24)

(25)

= E

t

and that the OU bridge {bst}0st is independent of {Xu}ut.

Thus {bst} is independent of t and

We deduce therefore that

1

St = E

Pt

Practical Quantitative Analysis in Commodities

t PuXu du.

PuXudu t, Xt .

(26)

t

c DC Brody 2010

-13 -

18 June 2010

We can use the orthogonal decomposition (10) to isolate the dependence of the

commodity price on the current level of the benefit rate Xt.

Remarkably, this turns out to be linear in our model.

Specifically, we have the following decomposition into orthogonal components:

PuXudu =

Pu Xu e(ut)Xt du

Pue(ut)du Xt.

(27)

Pue(ut)du Xt + E At tAt + Bt ,

(28)

+

t

Pt St =

t

where

At =

t

Pu Xu e(ut)Xt du,

(29)

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-14 -

18 June 2010

But now the problem is essentially solved, since the remaining expectation is of

the form

E [A|A + B] ,

(30)

where A and B are independent Gaussian random variables each with a known

mean and variance.

That is to say, we have:

A=

t

Pu Xu e(ut)Xt du

(31)

and

Bt

B= .

t

(32)

(33)

Writing

we observe in particular that A + B and (1 x)A xB are orthogonal and

hence independent if we set

Var[A]

x=

.

(34)

Var[A] + Var[B]

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-15 -

18 June 2010

This then enables us to work out the expectation to determine the value of the

commodity.

We proceed as follows.

First we note from (9) that

Xu e(ut)Xt = (1 e(ut)) + eu

esds.

(35)

Therefore, we have

A =

t

Pu Xu e(ut)Xt du

=

t

Pudu et

u=t

Pueu

Pueudu

esdsdu.

(36)

s=t

It follows that

E[A] = pt etqt ,

Practical Quantitative Analysis in Commodities

(37)

c DC Brody 2010

-16 -

18 June 2010

where

pt =

Pudu

(38)

Pueudu.

(39)

and

qt =

t

Pu e

e ds du =

Pueudu ds,

(40)

u=s

s=t

s=t

u=t

A E[A] =

=

s=t

es

Pueudu ds

u=s

esqsds.

(41)

Var[A] = 2

t

Practical Quantitative Analysis in Commodities

e2sqs2ds.

(42)

c DC Brody 2010

-17 -

18 June 2010

We also have

1

Var[B] = 2 .

t

The commodity price can then be worked out as follows.

(43)

We have

Pt St = E

PuXudu t, Xt

1

t etqtXt,

A+B =

t

and that E[A] is given by

(44)

(45)

E[A] = pt etqt .

(46)

t

PtSt = (1 xt) pt + e qt(Xt ) + xt .

t

(47)

c DC Brody 2010

-18 -

18 June 2010

2 2t t e2sqs2ds

.

xt =

2s 2

2

2

1 + t t e qs ds

(48)

Thus we see that for large and/or large the value of x tends to unity.

On the other hand, for small and/or small the value of x tends to zero.

Hence, if the market information has a low noise content (high ), then the

market information is what mainly determines the price of the commodity.

On the other hand, if the volatility of the benefit is high, then market

participants also rely heavily of the latest information in their determination of

prices.

The other term in the expression for St is essentially an annuitised valuation of a

constant benefit rate set at the mean reversion level, together with a correction

term to adjust for the present level of the benefit rate.

This term dominates in situations when the market information is of low quality.

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-19 -

18 June 2010

In other words, in the absence of information our judgements are formed on the

basis of a kind of average of the status quo and the long term average.

But we also rely on the status quo in situations where there is little uncertainty.

It should be evident that there is an interesting and rather complex set of

relations at work here.

The calculation above has been carried out in a deterministic interest rate

setting.

We can however pursue a similar analysis in a random interest rate environment.

Constant interest rate case

When the short rate is constant, we can make further simplification for the

commodity price valuation.

c DC Brody 2010

-20 -

18 June 2010

Pu = eru,

(49)

pt =

1 rt

e ,

r

qt =

1 (r+)t

e

,

r+

(50)

and

2 2t

.

xt =

2r(r + )2e2rt + 2 2t

A short calculation then shows that

1

t

1

1

St = (1 xt)

Xt + xt ert .

+

r r+

r+

t

(51)

(52)

c DC Brody 2010

-21 -

18 June 2010

120

Sim

Sim

Sim

Sim

Sim

Market

110

100

90

80

70

60

50

40

30

20

50

100

150

200

250

300

350

time

Figure 2:

Sample paths for the price process (colour) vs the market price for crude oil (black).

c DC Brody 2010

-22 -

18 June 2010

Let us now consider the problem of pricing a commodity derivative.

Specifically, we consider the valuation of a call option:

C0 = erT E (ST K)+ .

(53)

Recall that the commodity price process {St} in the OU model is a linear

function of the convenience yield

Xt = etX0 + (1 et) + et

esds,

(54)

t = t

eruXudu + Bt.

(55)

hand, where {Xt} and {Bt} are independent.

ru

Xudu},

t e

and {Bt} at

Since the sum of Gaussian processes is also Gaussian, the evaluation of the call

price reduces to the determination of the mean mT and the variance T2 of ST .

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-23 -

18 June 2010

X0 T

+

e

mT = (1 xT )

r

r+

(56)

and that

T2

2

e2rT

2

2T

2

1e

+ xT

+ 2 .

=

2

2

2(r + )

2r(r + )

T

(57)

PuXudu = At +

Pue(ut)du Xt

= At +

1 rt

e Xt ,

r+

(58)

Therefore, the commodity price (52) can be expressed in the form

1

1

1

rt

rt Bt

St = (1 xt)

Xt + xt e At + xt e

.

+

r r+

r+

t

(59)

However, the Gaussian processes {Xt}, {At}, and {Bt} are independent.

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-24 -

18 June 2010

Gaussian variables Xt in (7), At in (42), and Bt in (43).

Putting these together we obtain (57).

Returning to the call price valuation, we thus have

C0 = e

rT

2T

(z mT )2

dz.

(z K) exp

2T2

(60)

If we write

x

1

N (x) =

exp 12 z 2 dz

2

for the cumulative normal density function, then we obtain

(mT K)2

T

exp

C0 = e

2T2

2

for the price of a commodity option.

rT

+ (mT K)N

(61)

mT K

T

(62)

c DC Brody 2010

Figure 3:

-25 -

18 June 2010

Option price surface as functions of the initial asset price and option maturity.

c DC Brody 2010

-26 -

18 June 2010

10

12

14

The call option prices as functions of the initial asset price in the OU model. The parameters are set as

= 0.15, = 0.25, X0 = 0.6, = 0.15, r = 0.05, and K = 10. The three maturities are T = 0.5 (blue), T = 1.0

(green), and T = 3.0 (brown).

Figure 4:

c DC Brody 2010

-27 -

18 June 2010

We now consider the time-inhomogeneous Ornstein-Uhlenbeck process as a

simple model for the commodity convenience benefit.

In this case we have

dXt = t(t Xt)dt + tdt,

(63)

Defining the integral

t

sds,

ft =

(64)

we find, by use of the standard method involving an integration factor, that the

solution to (63) is given by

Xt = e

ft

fs

e ssds +

X0 +

0

efs sds .

(65)

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-28 -

18 June 2010

A short calculation establishes that for T > t we have

XT = e

tT s ds

Xt + e

0t s ds

u

0 s ds

uudu

+e

0t s ds

u

0 s ds

udu .

(66)

Furthermore, by use of the variance-covariance relations one can easily verify

T

that Xt is independent from XT e t sdsXt.

Similarly to the time-homogeneous case, this independence relation illustrates

the Markov property of the time-inhomogeneous OU process.

This property corresponds to an orthogonal decomposition of the form

XT = XT e

tT s ds

Xt + e

tT s ds

Xt

(67)

for T > t.

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-29 -

18 June 2010

As before, there is another orthogonal decomposition, this time for Xt, which

plays a crucial role in the time-inhomogeneous setup.

This decomposition is given by

Xt =

Xt

eft

efT

t 2fs 2

0 e s ds

T 2f 2

s

0 e s ds

XT

eft

efT

t 2fs 2

0 e s ds

T 2f 2

s

0 e s ds

XT .

(68)

btT = Xt

eft

efT

t 2fs 2

0 e s ds

T 2f 2

s

0 e s ds

XT

(69)

Clearly we have b0T = X0 and bT T = 0.

Valuation of the commodity price

The arguments presented in the foregoing material carry through in the case of

an extended OU model.

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-30 -

18 June 2010

1

PuXudu t, Xt .

St = E

(70)

Pt

t

We can use the orthogonal decomposition (67) to isolate the dependence of the

commodity price on the current level of the benefit rate Xt.

As before, this turns out to be linear in the benefit rate:

PuXudu =

Pu Xu e(fuft)Xt du

Pue(fuft)du Xt.

(71)

Pue(fuft)du Xt + E At tAt + Bt ,

(72)

+

t

Pt St =

t

where

At =

t

Pu Xu e(fuft)Xt du,

(73)

Practical Quantitative Analysis in Commodities

c DC Brody 2010

-31 -

18 June 2010

We close by remarking that in the case of an equity-type asset a model based on

a geometric Brownian motion might be feasible for the cash flow.

Consider a simple example in which the dividend process satisfies the stochastic

equation

dXt = Xtdt + Xtdt,

(74)

where and > 0 are constants, and {t} is a standard Q-Brownian motion.

Assuming for simplicity that the short rate {rt} is also a constant given by r, we

have, for the cumulative dividend, the expression

Z = X0

1 2 )s

es(r+ 2

ds.

(75)

1

r + 2 > 0.

2

Then a standard result on geometric Brownian motion shows that Z is

Practical Quantitative Analysis in Commodities

(76)

c DC Brody 2010

-32 -

18 June 2010

g(z) =

2X0

2

z 1e /(2X0z)

,

()

(77)

where = 1 + 2 2(r ).

The price process of the asset is then obtained by defining the information

process {t} of (18) according to

t = tZ + Bt.

Zt

1

St = E [Z| t, Xt] ,

Pt

Pt

where

t

Zt = X0

s (r+ 12 2)s

ds.

(78)

(79)

(80)

c DC Brody 2010

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