Commodity Modelling: Schwartz Two-Factor Model

Zurich University
of Applied Sciences
School of
Engineering
IDP Institute of
Data Analysis and
Process Design
Commodity Modelling
Schwartz two-factor model
Philipp Erb IDP Winterthur David Lthi Clariden Leu Zrich
July 2, 2009
Commodity Modelling 1 / 33
Outline
1 Motivation
2 Commodity model types
3 Schwartz two-factor model in a nutshell

Model dynamics
Joint distribution of state variables
Pricing of basic derivatives
Risk measures
4 Using schwartz97
Parameter Estimation
Examples
IDP Winterthur, Clariden Leu Zrich

Motivation
Motivation and Context
CTI project between IDP and FRSGlobal
Extending FRSGlobals softwaretool riskpro with commodity models
Schwartz fator model: Basic model

A Hinz model: More advanced model
Implementation of protoype models in R
No commodity models on CRAN so far

Launching commodity model package schwartz97

Commodity model types
Outline
1 Motivation
Model dynamics
Risk measures
4 Using schwartz97
Examples

Spot price models: E.g. Schwartz factor models
Few parameters
Inflexible term sturcutre of futures prices
Futures price models: E.g. HJM type model by Juri Hinz
Numerous parameters
Flexible term sturcture generic

Schwartz factor models

One-factor model
Spot price Log-price mean-reverting (Ornstein-Uhlenbeck)
Two-factor model
Spot price Log-normal (Geometric Brownian motion)
Convenience yield Mean-reverting (Ornstein-Uhlenbeck)
Three-factor model
Spot price Log-normal (Geometric Brownian motion)
Convenience yield Mean-reverting (Ornstein-Uhlenbeck)
Interest rate Mean-reverting (Vasicek)
Empirical study: Two-factor model most-parsimonious choice

Schwartz two-factor model in a nutshell
Outline
1 Motivation

Model dynamics
Risk measures
4 Using schwartz97
Examples

Model dynamics: Two-factor model

The P-dynamics:
dSt = ( t ) St dt + S St dWS
dt = ( t ) dt + dW
dWS dW = dt
The Q-dynamics:
S
dSt = (r t ) St dt + S St d W

dt = [ ( t ) ] dt + d W
SdW
dW = dt

Outline
1 Motivation
Model dynamics
Risk measures
4 Using schwartz97
Examples

Log-price X := log S and convenience yield joint normal

Solve SDE under P and Q and compute first two moments:
I Distribution under P and Q
2
X P X X X
=N = , = ,
X 2
2
X Q
X X X
=N = , =

X 2
Basic tool for all computations

(pricing, simulation, risk measures, calibration)

Outline
1 Motivation

Model dynamics
Risk measures
4 Using schwartz97
Examples

Futures
Futures prices:
1 2
G(S0 , 0 , T ) = EQ [ST ] = e X + 2 X
= S0 e A(T )+B(T )0
with

1 2 S 1 2 1 e 2T
A(T ) = r
+ T+
2 2 4 3

2 1 e T
+ + S
,
2
e T 1
B(T ) =


Futures
Affine term structure of futures prices:

log G(T ) = X0 + B(T )0 + A(T )
Model can be cast in state space form
Both state variables (factors: Xt , t ) unobservable

Kalman filter

European Options

log G(T ) = X0 + B(T )0 + A(T )
Futures prices log-normal
BS-type formulas for European options on futures

European Options
European call option:
C G = EQ e r t (G(St , t , T t) K )+

= P(0, t) {G(0, T )(d+ ) K (d )}

with
G(0,T )
log K
21 2
d = ,

2

2 2 2S 1 T t
1 2T 2t
2 T t
= S t + e e 1 t + t+ e e 1 e e 1
2 2
Put-call parity:
C G P G = P(0, t) {G(0, t) K }
European put option:
P G = P(0, t) {K (d ) G(0, T )(d+ )}

Outline
1 Motivation

Model dynamics
Risk measures
4 Using schwartz97
Examples

Risk Measures

log G(T ) = X0 + B(T )0 + A(T )

Futures log-price Gaussian: log G N G , G2
Losses (negative log-returns) Gaussian
Closed formulas for value at risk (VaR) and expected

shortfall (ES) for futures contracts

Using schwartz97
Outline
1 Motivation
Model dynamics
Risk measures
4 Using schwartz97
Examples

Using schwartz97
Function Overview: Usual d/p/q/r style
If all parameters are known, the transition density is known.

For a fixed point in time, the distribution is defined.
d/p/q/r-state d/p/q/r functions for the bivariate state variables.
simstate Generate trajectories from the state variables.
d/p/q/r-futures d/p/q/r functions for the log-normal futures prices.

Using schwartz97
Function Overview: Estimation, pricing, risk
fit2factor Fit parameters to data.
pricefutures Calculate futures prices.
priceoption Price a European call or put option written on a futures

contract.
VaR/ES-futures Value-at-risk and Expected-shortfall of futures prices.
filter2factor Filter a futures price series and obtain the state

variables.

Using schwartz97
Object Orientation
Problem: Many parameters involved
The transition density of the state variables depends on 8 parameter:
(s0 , 0 , , S , , , , )
The transition density of the futures price depends on 10 parameter:

(s0 , 0 , , S , , , , , , r )
Idea: 3 levels of encapsulation

Raw parameters.
schwartz2factor-class
fit.schwartz2factor-class

Using schwartz97
Example: dfutures
dfutures(x, ttm = 1, s0 = 50, delta0 = 0,

mu = 0.1, sigmaS = 0.3, kappa = 1, alpha = 0,
sigmaE = 0.5, rho = 0.75, r = 0.05, lambda = 0,
alphaT = NULL, ...)
## S4 method for signature ANY, ANY, schwartz2factor:

dfutures(x, ttm = 1, s0, r = 0.05, lambda = 0,
alphaT = NULL, ...)
## S4 method for signature ANY, ANY, fit.schwartz2factor:

dfutures(x, ttm = 1, s0, ...)

Using schwartz97
Outline
1 Motivation

Model dynamics
Risk measures
4 Using schwartz97
Examples

Using schwartz97
State Space Representation
Transition equation:
The state variables are log-spot price and convenience yield.
t+1 = dt + Tt t + Ht t , t N (0, I2 ) (4.1)
Measurement equation:
Futures prices are measured. The log-futures price are an affine
function of the log-spot price and the convenience yield.
yt = ct + Zt t + Gt t , t N (0, In ) (4.2)

Using schwartz97
State Space Model: Transition Equation
t+1 = dt + Tt t + Ht t , t N (0, I2 ) (4.3)
!
Xt+t
t+t = (4.4)
t+t
!
1 1
e t 1
Tt = (4.5)
0 e t

12 S2 t +
1 e t
dt = (4.6)
1 e t
!
0 X2 (t) X (t)
Ht Ht = (4.7)
X (t) 2 (t),
where Xt = log St and t = tk+1 tk .
Using schwartz97
State Space Model: Measurement Equation
yt = ct + Zt t + Gt t , t N (0, In ) (4.8)

log Gt (1) 1 B(mt (1))
.. .
. ..
yt =
.
Zt =
. .
(4.9)
log Gt (n) 1 B(mt (n))

A(mt (1)) 2
g11
.
..
0 ..
ct =

Gt G =
t .
(4.10)
A(mt (n)) 2
gnn
where mt (i) denotes the remaining time to maturity of the i-th
closest to maturity futures Gt (i).

Using schwartz97
Function fit2factor
fit2factor(data, ttm, deltat = 1 / 260,

s0 = data[1,1], delta0 = 0,
mu = 0.1, sigmaS = 0.3, kappa = 1, alpha = 0, sigmaE = 0.5,
rho = 0.75, lambda = 0,
meas.sd = rep(0.02, ncol(data)),
opt.pars = c(s0 = FALSE, delta0 = FALSE, mu = TRUE, sigmaS = TRUE,
kappa = TRUE, alpha = TRUE, sigmaE = TRUE,
rho = TRUE, lambda = TRUE),
opt.meas.sd = c("scalar", "all", "none"),
r = 0.05, silent = FALSE, ...)

Using schwartz97
Outline
1 Motivation
Model dynamics
Risk measures
4 Using schwartz97
Examples
Using schwartz97
Function fit2factor
> library(schwartz97)
Loading required package: FKF
Loading required package: mvtnorm
> data(futures)
> na.idx <- apply(is.na(copper$futures), 1, any)
> copper.fit <- fit2factor(copper$futures[!na.idx,], copper$ttm[!na.idx,],
+ control = list(maxit = 100, reltol = 1e-3),
+ silent = TRUE)
>

Using schwartz97
Function fit2factor
> copper.fit
----------------------------------------------------------------
Fitted Schwartz97 2 factor model:
d S_t = S_t * (mu - delta_t) * dt + S_t * sigmaS * dW_1
d delta_t = kappa * (alpha - delta_t) * dt + sigmaE * dW_2
E(dW_1 * dW_2) = rho * dt
s0 : 109.375364269883
delta0: 0
mu : 0.212827842930593
sigmaS: 0.37460428511304
kappa : 1.10747274866091
alpha : 0.0595560374598207
sigmaE: 0.474809676990843
rho : 0.813002684142751
r : 0.05
lambda: 0.0402214875501909
alphaT: 0.0232377735577751
----------------------------------------------------------------
Optimization information
Converged: TRUE
Fitted parameters: mu, sigmaS, kappa, alpha, sigmaE, rho, lambda, meas.sd1; (Num
log-Likelihood: 112485.1
Nbr. of iterations: 75
----------------------------------------------------------------
>

Using schwartz97
Function filter2factor
> filter2factor(copper$futures[!na.idx,], copper$ttm[!na.idx,], copper.fit)
>
350
Spot price
Closest to maturity futures
200
50
0 1000 2000 3000 4000 5000
Index
0.5
Convenience yield
0.2
0.1
0 1000 2000 3000 4000 5000
Index
Using schwartz97
Derivatives
> pricefutures(ttm = 3, copper.fit)

[1] 107.1682
> priceoption("call", time = 2, Time = 3, K = 110, copper.fit)
[1] 12.33399
>

Using schwartz97
Conclusion & Outlook
Conclusion
(Optimal??) trade-off: Statistical tractability vs. sophistication.

Stylized model.
First step towards commodity modelling in R.
Outlook
Implementing term-structure models (Juri Hinz & Max Fehr, 2007).

Using schwartz97
References
Rajna Gibson and Eduardo S. Schwartz.

Stochastic convenience yield and the pricing of oil contingent claims.
The Journal of Finance, 45(3):959976, 1990.
Eduardo S. Schwartz.
The stochastic behavior of commodity prices: Implications for valuation and
hedging.
Journal of Finance, 52(3):923973, 1997.
Kristian R. Miltersen and Eduardo S. Schwartz.
Pricing of options on commodity futures with stochastic term structures of
convenience yields and interest rates.
Journal of Financial and Quantitative Analysis, 33:3359, 1998.

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Zurich University

Schwartz two-factor model

Philipp Erb IDP Winterthur David Lthi Clariden Leu Zrich

2 Commodity model types

3 Schwartz two-factor model in a nutshell

IDP Winterthur, Clariden Leu Zrich

Motivation and Context

CTI project between IDP and FRSGlobal

Extending FRSGlobals softwaretool riskpro with commodity models

Schwartz fator model: Basic model

Implementation of protoype models in R

No commodity models on CRAN so far

IDP Winterthur, Clariden Leu Zrich

IDP Winterthur, Clariden Leu Zrich

Commodity model types

Spot price models: E.g. Schwartz factor models

Futures price models: E.g. HJM type model by Juri Hinz

IDP Winterthur, Clariden Leu Zrich

Schwartz factor models

Empirical study: Two-factor model most-parsimonious choice

IDP Winterthur, Clariden Leu Zrich

2 Commodity model types

3 Schwartz two-factor model in a nutshell

IDP Winterthur, Clariden Leu Zrich

Model dynamics: Two-factor model

IDP Winterthur, Clariden Leu Zrich

IDP Winterthur, Clariden Leu Zrich

Joint distribution of state variables

Log-price X := log S and convenience yield joint normal

Basic tool for all computations

IDP Winterthur, Clariden Leu Zrich

2 Commodity model types

3 Schwartz two-factor model in a nutshell

IDP Winterthur, Clariden Leu Zrich

IDP Winterthur, Clariden Leu Zrich

Affine term structure of futures prices:

Both state variables (factors: Xt , t ) unobservable

IDP Winterthur, Clariden Leu Zrich

Affine term structure of futures prices:

Futures prices log-normal

BS-type formulas for European options on futures

IDP Winterthur, Clariden Leu Zrich

= P(0, t) {G(0, T )(d+ ) K (d )}

IDP Winterthur, Clariden Leu Zrich

2 Commodity model types

3 Schwartz two-factor model in a nutshell

IDP Winterthur, Clariden Leu Zrich

Affine term structure of futures prices:

Losses (negative log-returns) Gaussian

Closed formulas for value at risk (VaR) and expected

IDP Winterthur, Clariden Leu Zrich

IDP Winterthur, Clariden Leu Zrich

Function Overview: Usual d/p/q/r style

If all parameters are known, the transition density is known.

d/p/q/r-state d/p/q/r functions for the bivariate state variables.

simstate Generate trajectories from the state variables.

d/p/q/r-futures d/p/q/r functions for the log-normal futures prices.

t+1 = dt + Tt t + Ht t , t N (0, I2 ) (4.1)

t+1 = dt + Tt t + Ht t , t N (0, I2 ) (4.3)