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Philip Thomas Date : 18th Oct 2013

**Mean Reversion Model
**

Mean reverting model has been one of the stochastic processes that often used in oil price modelling. The mean reversion is an Ornstein-Uhlenbeck (O-U) process that model the price of commodities like a spring which pulls back the price deviation into the mean. In here, the equations which used in the algorithm will be shown. The notations presented refer to Smith & Mccardle (1999) where they discussed the use of mean reversion model with the drift. The general equation of the mean reverting model in Smith & McCardle (1999) where π (t) = ln (p(t)) is : (1)

dπ (t) = κ (¯ π − π (t)) + σπ dzπ

where π ¯ denotes the long-run mean to which the log prices revert, κ describes the strength of mean reversion, σπ describes the volatility of the process and

dzπ (t) represents increments of a standard brownian motion process.

**Refer to Dixit and Pindyck (1994),π (t) in equation 1 has
**

bution

normal distri-

**with the mean and variance as follow:
**

σ2 2η

E [π (t)] = π (0)e−ηT + 1 − e−ηT π ¯ V ar[π (t)] = 1 − e−2ηT

1

1) where in our case.Numerical Solution The general discretization of one factor O-U process is given by: xt = xt−1 e−η t +x ¯ 1 − e −η t +σ 1−e −2η t 2η N (0. we can get the solution for sampling the path of non-risk adjusted commodity price: p(t) = exp ln (p(t − 1)) e−κ t + ln (¯ p ) 1 − e −κ t +σ 1−e −2κ t 2κ N (0. etc. 6 months. 2 months. However. 1) − 1 − e−2κ t σ2 4κ (2) This is the equation that we use in our algorithm. Input inputs required in the model are: • t the discretization time frame that we use in our calculations (e. 1 month. Since we dene π (t) = ln (p(t)).g. 1 year.) • p ¯ 2 .5V ar[π (t)]} By substituting the terms π (t) and V ar[π (t)] in the equation above. xt = π (t).. this is compensated by: p(t) = exp {π (t) − 0. E [p(t)] = eE [π(t)] due to the exponential of a normal dis- tribution adds the half of the variance in the log-normal distribution mean. Therefore. then the model should be set to E [p(t)] = eE [π(t)] . η = κ.

the mean of the price that is revert to within the analysis time frame • σ standard deviation of our sampling path.5) = κH H= −ln(0.. We get : κdt ln = −κ t denition of Half-life → (π (1) − π ¯ ) = 0.... recall arithmethic O-U: dπ (t) = κ (¯ π − π (t)) dt+σπ dzπ where E [dπ (t)] = κ (¯ π − π (t)) dt we take the integration of ´ π(t)=1 dπ (t) π −π (t)) π (t)=0 (¯ (π (1)−π ¯) (π (0)−π ¯) dπ (t) (¯ π −π (t)) = ´ t1 t0 from 0 to 1.. The denition of half-life is the time that the current price needs to revert half-way to the mean reversion level which can be derived from Eq. This also can be described by Half-Life (H)..5 (π (0) − π ¯ ) Therefore. Q.D 3 . which can be calibrated in the further process • η the mean reversion rate of our model....E.. −ln(0....1....5) κ as shown in Smith & McCardle (1999).

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Numerical Solution for oil price modelling

Numerical Solution for oil price modelling

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