t
is the long term equilibrium process:
t
= p
{
+o
{
t
{
[
t
t
{
= p
10 MODELLING THE FUTURE CURVE
SHORT TERM / LONG TERM MODEL
Under these assumptions the future prices are lognormal variables:
ln

F(t, T)]
=
k(1t)
_
t
+
t
+ ( )
ln

F(t, T)]
] =
k1
_
0
+
0
+ p
{
+ ( )
vailn

F(t, T)]
] =
2k1
(
2kt
1)
c
_
2
2k
+o
{
2
+2
k1
(
kt
1)
c
_
c
(
k
() is a deterministic function:
() = p
{
+
1
2
(1
2k1
)
o
2
2
+ o
{
2
+2(1
k1
)
o
o
{
11 MODELLING THE FUTURE CURVE
SHORT TERM / LONG TERM MODEL
Although, as shown in the SchwartzSmith paper, this approach is
equivalent to a stochastic convenience model, it is probably more intui
tive due to the break down between short and long term drivers.
_
t
is a mean reverting process which has more impact on short
dated maturities.
t
creates parallel shifts of the curve
Short dated futures tend to revert to the long run equilibrium
regime which is driven by
t
These variables are however not observable
12 MODELLING THE FUTURE CURVE
FUTURE CURVE MODEL
The previous approach consists in defining the spot price driving vari
ables and to deduce the corresponding future prices dynamic. Alterna
tively we can directly model the future price:
uF(t, T) = F(t, T)
I
(t, T) uW
t
I
I
The short term / long term model corresponds to a specific formula
tion of the volatility functions
I
(t, T) where the number of factors is
set to 2.
In a more general setting the number of Brownian processes W
t
I
can
be reduced by PCA techniques.
MODELLING THE FUTURE CURVE 13
FUTURE CURVE MODEL
A more generic formulation of the short term long term future curve
model can therefore be expressed as follows:
F(t, T
I
) = F(u, T
I
) exp _
1
2
i
(t, T)
2
+
k(T
t)
_
t
+
t
_
Where
F(u, T
I
) is the current price of the future contract expiring at T
I
.
_
t
=
kt
]
ku
o
()
u
t
0
t
= ] o
{
()
u
{
t
0
[
t
t
{
= p
I
(t, T) =
_
2kT
]
2ku
o
()
2
+
t
0
] o
{
()
2
+
t
0
kT
]
ku
o
()o
{
()
t
0
14 CALIBRATION
CALIBRATION
15 CALIBRATION
KALMAN FILTER
In their original papers GibsonSchwartz and SchwartzSmith propose to
estimate the model parameters with a Kalman filtering technique.
The kalman filter is a recursive method for estimating non observable
variables from observable variables.
Kalman results can be statically unstable.
There is no guarantee that this procedure would produce a set of pa
rameters consistent with implied volatilities.
The model should be in line with the term structure of volatilities if we
want to use the corresponding options for hedging.
16 CALIBRATION
LISTED OPTIONS
Similarly to the future market there exists a listed commodity market
for options: For each future contract there generally exist Call and Put
options expiring shortly before the corresponding future maturity .
These options are the basic instruments of choice for the
hegdge of Vega risks linked to more complex derivatives
They imply a term structure of implied volatilities but contrary
to other markets the underlying is different for each maturity:
In Equity markets a term strucure of volatility defines a
strip of option prices on the same asset observed at
different times.
In most commodity markets each volatility point
corresponds to a unique future underlying expiry.
CALIBRATION 17
TERM STRUCTURE OF VOLATILITY
A term structure of volatility represents the variation of volatility with
maturity.
It is common to represent the atthemoney volatilities to illustrate
the term structure.
Commodity term structures tend to be downward sloping. It can be
explained by the mean reverting nature of these markets.
Each volatility point of the term structure corresponds to a unique
future contract point
18 CALIBRATION
TERM STRUCTURE OF VOLATILITY
19 CALIBRATION
TERM STRUCTURE OF VOLATILITY
Although volatility term structure varies with time, the downward slop
ing profile is a persistent characteristic of volatility term structures.
By time homogeneity we can deduce that the volatility term struc
ture of a fixed future contract should be upward sloping
(Samuelson effect).
This is consistent with the short term/long term model:
vai lnF(t, T)] =
2
(
2
1)
o
_
2
2
+2
1)
o
_
o
+o
2
The first two terms are bounded as t & T tends to infinity
i.e. the corresponding volatility is decreasing towards 0.
When T is fixed the first two terms are increasing with t.
20 CALIBRATION
VOLATILITY TERM STRUCTURE CALIBRATION
But calibration to ATM volatilities will not provide a unique solution.
= 116%,
= 11u%,
= 2S%, = 88%
21 CALIBRATION
VOLATILITY TERM STRUCTURE CALIBRATION
Another satisfactory calibration:
= 22S%,
= 9u%,
= 18%, = 2u%
CALIBRATION 22
VOLATILITY TERM STRUCTURE CALIBRATION
The previous calibrations are obtained by global minimization of the
differences between listed options implied volatilities and the corre
sponding volatilities computed with the two factors model parame
ters (with constant instantaneous volatilities
and
{
).
Another approach consists in extrapolating
{
from the term struc
ture of volatility as it corresponds to the implied volatility limit
(
_
VarInF(t,T)]]
t
) when (t, T) tend toward infinity:
Each point of the ATM volatility term structure can then be
exactly matched by introducing piecewiseconstant instanta
neous volatilities o
().
However there is no unique solution: each couple (, ) will
lead to a different o
() profile.
CALIBRATION 23
VOLATILITY TERM STRUCTURE CALIBRATION
In order to illustrate the previous calibration method let us denote by
(t
I
, o
A1M
()) the market option maturities and corresponding ATM implied
volatilities (to simplify the calculations we assume p = u).
If we suppose that (, ) are known it remains to define o
() = o
() for
]
,
+1
] such as
2kT
]
2ku
o
()
2
+
t
i
0
o
{
2
=
I
2
= 1
It implies the following result:
o
()
2
=
(o
A1M
()
2
o
{
2
)
2k(T
T
1
)
(o
A1M
( 1)
2
o
{
2
)
1
2kT
2
(
2kt
2kt
1
)
It can only be solved if
(o
A1M
()
2
o
{
2
)
2k(T
T
1
)
(o
A1M
( 1)
2
o
{
2
)
1
u
CALIBRATION 24
VOLATILITY TERM STRUCTURE CALIBRATION
We have seen that calibrating (, ) to the term structure of volatility can
generate different results:
Two acceptable calibrations can create different correlation profiles
of the future curve.
The volatility term structure profileo(, ) of a given future contract
implied by the model is mainly driven by the mean reversion
level:
o(, ) = _
2k1
(
2kt
1)
o
2
2
+2
k1
(
kt
1)
o
o
{
+o
{
2
_
1
2
,
CALIBRATION 25
VOLATILITY TERM STRUCTURE CALIBRATION
Volatility term structure of a fixed contract
CALIBRATION 26
HISTORICAL FUTURE PRICES
When no additional type of option quotes (swaptions, time spread
options) relevant for the calibration of the mean reversion/correlation
are available, an alternative solution is to use historical future prices.
Let us consider historical future prices
{
F(t, t +
I
)]
0<t<M
0<I<N
, where t
represent past observation dates, and
I
are constant expiries (they
are in fact approximated by the average time to maturity of the kth
nearest future).
We focus on the stochastic term
i
(t) of the corresponding loga
rithmic returns n _
F(t+t,t+t+
i
)
F(t,t+
i
)
_:
(t) = _
k(t+t+
u)
o
t+t
0
_
k(t+
u)
o
+
t
0
kT
_ o
{
u
{
t+tt
t
CALIBRATION 27
HISTORICAL FUTURE PRICES
With a local expansion around t~u, we can write
or
(t)] = 
k
]
2
+o
{
2
t +(t
2
)
Up to the first order of t, the stochastic terms of the logarithmic re
turns are independent and equidistributed:
(t)~u, 
k
]
2
+o
{
2
t
Similarly we can compute the covariances c
]
(, o
, o
{
) corresponding
to two different contracts:
c
]
(, o
, o
{
) = _
k(
+
]
)
o
2
+o
{
2
] t
The calibration method consists in minimizing the differences between
the model and the historical covariances.
CALIBRATION 28
HISTORICAL FUTURE PRICES
= 84%,
= 17%,
{
= 2u%, = 19.S9%
29 CALIBRATION
VOLATILITY SEASONALITY
In some markets, for example Henry Hub natural Gas, the term struc
ture of volatility is strongly seasonal.
It can be explained by higher demand, and therefore volatility, during
heating periods in winter.
The short term/long term breakdown cannot explain these term struc
tures, alternative approaches have to be considered.
Each month of the year can be modelled by a distinct underlying creat
ing twelve different term structure of implied volatilities.
30 CALIBRATION
VOLATILITY SEASONALITY
A typical Natural Gas term structure of ATM volatilities
31 CONCLUDING REMARKS
VOLATILITY SEASONALITY
Natural Gas ATM volatilities with the
August and November months highlighted.
CALIBRATION 32
VOLATILITY SEASONALITY
Each season can be calibrated separately and it remains to define the
correlations between summer and winter:
ln

F
Summcr
(t, T)]
=
k
S
(1t)
_
t
S
+
t
S
+
S
( )
ln

F
WIntcr
(t, T)]
=
k
W
(1t)
_
t
w
+
t
w
+
w
( )
The summerwinter correlations can be estimated by historical
analysis or implied from Calendar spread options, the most liquid
pairs being MarchApril and OctoberJanuary.
[
t
t
{
W
= p
{
Sw
, [
t
{
s
W
= p
{
Sw
[
t
W
= p
Sw
, [
t
{
s
t
{
W
= p
{
Sw
CALIBRATION 33
HEDGING CONSIDERATIONS
Different calibration methods will imply different hedging strategies.
Let us assume two different approaches where the mean reversion is
calibrated to historical covariances. We want to price a calendar spread
option:
(
1
,
1
) (
1
,
2
)]
+
Forward model:
uF(t, T
I
) = F(t, T
I
)
I
(t, T
I
) uW
t
I
Each volatility function
I
(t, T
I
) is calibrated separately to the appropri
ate ATM volatility point.
CALIBRATION 34
HEDGING CONSIDERATIONS
Short term/long term model ( = u):
ln

F(t, T
I
)]
= +
k1
_
ku
t
0
o
(u)
t
+o
{
t
{
o
{
is calibrated to the implied volatility curve asymptote:
vailnF(t, T)]]
t
t,T
 o
{
2
= o
A1M
2
()
o
2k1
i
_
2ku
t
i
0
o
2
() +o
A1M
2
()
= o
A1M
2
(i)
2
() =
2k1
i
o
A1M
2
() o
A1M
2
()]
2k1
i1
1
o
A1M
2
( 1) o
A1M
2
()]
2kt
i
2kt
i1
2
CALIBRATION 35
HEDGING CONSIDERATIONS
With the Forward model the value of the Calendar spread option de
pends on both volatilities
ATM
(i
1
) and
ATM
(i
2
).
With the short term/long term model the value of the Calendar spread
option depends on both volatilities
ATM
(i
1
) and
ATM
().
Alternatively a short term/long term model can be calibrated to a few
fixed points of the ATM volatility term structure (the more liquid) and
the Vega profile of any options will be depend on the calibrated points
only.
CALIBRATION 36
CONCLUDING REMARKS
Multiple factors are necessary to correctly represent the variations
of the future curve.
To obtain satisfactory calibration  stable and in line with vanilla op
tions  one has to combine different approaches (minimization, sta
tistical estimation).
The calibration procedure impacts directly the risk profile and there
fore should be decided accordingly to a hedging strategy.
37 REFERENCES
REFERENCES
Rajna Gibson; Eduardo S. Schwartz. Stochastic Convenience Yield and the Pricing of Oil
Contingent Claims. The Journal of Finance, Vol. 45, No. 3, Papers and Proceedings, Forty
ninth Annual Meeting, American Finance Association, Atlanta, Georgia, December 2830,
1989. (Jul., 1990), pp. 959976.
Eduardo Schwartz; James E. Smith. ShortTerm Variations and LongTerm Dynamics in
Commodity Prices. Management Science Vol. 46, No. 7, July 2000 pp. 893911
Helyette Geman. Commodities and Commodity Derivatives: Pricing and Modeling Agricul
tural, Metals and Energy, January 2005, Wiley Finance