Abstract:
This study builds a reduced form of the three factor commodity derivative valuation model by
explicitly taking into account the unobservable character of the convenience yield and extends
the existing literature on commodity derivative by introducing a new feature, which is Vasicek
interest rate model is replaced by CIR interest rate process to prevent the interest rate from
going to negative. The spot price process, the instantaneous convenience yield and CIR interest
rate process are taken in the reduced form of the three factor commodity derivative valuation
model. We study the reduced form of the three factor commodity derivative valuation model
based on discretization schemes. We simulate the reduced form the three factor commodity
derivative valuation model by using the two known discretization schemes, i.e, Milstein and
Euler discretization schemes. We study the performance of Milstein and Euler discretization
schemes theoretically and empirically in reduced form the three factor commodity derivative
valuation model. The Milstein discretization scheme has better approximation than Euler
discretization scheme in reduced form the three factor commodity derivative valuation model.
As the time of maturity, T, is less and the time interval decreases the result obtained from
the simulation of reduced form the three factor commodity derivative valuation model for
spot price process, convenience yield and interest rate process has better approximation. In
addition, the data used to test reduced form of the three factor commodity derivative valuation
model involves futures contracts from commodity market.
