Unspanned Stochastic Volatility and the Pricing of Commodity Derivatives
We conduct a comprehensive analysis of unspanned stochastic volatility in commodity markets in general and the crude-oil market in particular. We present model-free results that strongly suggest the presence of unspanned stochastic volatility in the crude-oil market. We then develop a tractable model for pricing commodity derivatives in the presence of unspanned stochastic volatility. The model features correlations between innovations to futures prices and volatility, quasi-analytical prices of options on futures and futures curve dynamics in terms of a low-dimensional affine state vector. The model performs well when estimated on an extensive panel data set of crude-oil futures and options.
The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.
Anders B. Trolle & Eduardo S. Schwartz, 2009. "Unspanned Stochastic Volatility and the Pricing of Commodity Derivatives," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 22(11), pages 4423-4461, November.