A Reduced Form of the Three Factor Commodity Derivative Valuation Model

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.