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Pricing Storable Commodities and Associated Derivatives

Dorje C. Brody
Department of Mathematics,
Imperial College London,
London SW7 2AZ
www.imperial.ac.uk/people/d.brody

(London: 18 June 2010)


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Market information about future supply, demand, and inventory


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
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an uncorked bottle of the same wine.


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)

is the discount factor.


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.
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Then Pt is determined by the initial term structure.


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)

where the Q-Brownian motion {Bt} is independent of {Xt}; and


(b) the commodity convenience benefit flow process {Xt}t0.
Thus, at time t we have
Ft = {s}0st, {Xs}0st .

(4)

In other words, the market information is generated jointly by the convenience


benefit flow up to time t and the noisy information of the future benefit flow.
Modelling the convenience benefit process
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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
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and the intertemporal covariance


2 T t
e
e et .
Cov[Xt, XT ] =
2

(8)

Applications of Ornstein-Uhlenback bridges


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)

This expression is appropriate when we re-initialise the process at time t.


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
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(10)
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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)

The process {btT }0tT defined for fixed T by

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.
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(12)

(13)

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The OU bridge is a Gaussian process with mean


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)

Valuation formula for the commodity price


Armed with these facts, now we shall show that

E
t

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

PuXudu t, Xt . (16)

This will simplify the calculations that follow later.


First we note that
Ft = {s}0st, {Xs}0st
= {s}0st, {Xs}0st ,
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(17)
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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:

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where

t = t

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PuXudu + Bt.

(18)

This follows from the fact that


t

t = t t

PuXudu.

(19)

We then observe further that


t s

Ft = t,
t
s

0<st

, {Xs}0st .

(20)

We note that {t} has the Markov property, since

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.
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(22)

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This can be seen as follows.


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.

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Thus, we conclude that the price is given by

Pt St = E
t

= E
t

= E
t

PuXudu Ft
PuXudu t, Gt, {Xs}0st
PuXudu t, {Xs}0st
PuXudu t, {Xs}0st .

(24)

t, {Xs}0st = (t, Xt, {bst}0st) ,

(25)

= E
t

But note on the other hand that


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
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t PuXu du.

PuXudu t, Xt .

(26)

t
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Commodity price process


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

Thus, we deduce that

Pt St =
t

where

At =
t

Pu Xu e(ut)Xt du,

(29)

and Bt is the value of the Brownian motion at time t.


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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)

A = x(A + B) + (1 x)A xB,

(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]
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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 ,
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(37)
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where

pt =

Pudu

(38)

Pueudu.

(39)

and

qt =
t

By interchanging the order of integration we can write

Pu e

e ds du =

Pueudu ds,

(40)

u=s

s=t

s=t

u=t

and therefore we have


A E[A] =
=

s=t

es

Pueudu ds

u=s

esqsds.

(41)

Thus, by the Wiener-Ito isometry, we obtain

Var[A] = 2
t
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e2sqs2ds.

(42)
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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

= etqtXt + x(A + B) + (1 x)E[A] xE[B].

Note that E[B] = 0, and that A + B is given by


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)

Gathering terms, we therefore obtain

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The weighted factor xt is given by

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.
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It also dominates in situations when the benefit volatility is low.


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.

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In this case we have


Pu = eru,

(49)

from which it follows that


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

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(51)

(52)

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psi = 0.4, kappa = 0.05, sigma = 0.05


120

Sim
Sim
Sim
Sim
Sim
Market

110

100

90

Brent Crude Price

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).

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Pricing commodity derivatives


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)

and also in the information process

t = t

eruXudu + Bt.

(55)

Thus we have three Gaussian processes {Xt}, {


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 .
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A short calculation shows that


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)

These can be obtained from the orthogonal decomposition (27):

PuXudu = At +

Pue(ut)du Xt

= At +

1 rt
e Xt ,
r+

(58)

where {At} is defined in (29).


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.
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It follows that the variance of St is determined by the variance of the three


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

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+ (mT K)N

(61)

mT K
T

(62)

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Figure 3:

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

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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:

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Extended mean-reversion models for the convenience dividend


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)

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


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)

Orthogonal decompositions: time-inhomogeneous OU bridge


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


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)

This expression is appropriate when we re-initialise the process at time t.


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.
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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)

The process {btT }0tT defined for fixed T by


btT = Xt

eft

efT

t 2fs 2
0 e s ds
T 2f 2
s
0 e s ds

XT

(69)

is the time inhomogeneous Ornstein-Uhlenbeck bridge.


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.
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We are required therefore to calculate

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

Thus, we deduce that

Pt St =
t

where

At =
t

Pu Xu e(fuft)Xt du,

(73)

and Bt is the value of the Brownian motion at time t.


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Valuation of general assets: real estate


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)

We assume, further, that


1
r + 2 > 0.
2
Then a standard result on geometric Brownian motion shows that Z is
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(76)

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inverse-gamma distributed with density


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.

Specifically, the problem reduces to evaluating


Zt
1
St = E [Z| t, Xt] ,
Pt
Pt
where
t

Zt = X0

s (r+ 12 2)s

ds.

(78)

(79)

(80)

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