Subordinated Levy Processes and Applications to Crude Oil Options
IMF Working Papers, September 1, 2005
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- Subordinated Levy Processes and Applications to Crude Oil Options
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Bibliographic details
- Authors: Noureddine Krichene
- Published: September 1, 2005
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451861938.001
Summary
- One approach to oil markets is to treat oil as an asset, besides its role as a commodity.
- Speculative and nonspeculative activity by investors in the derivatives markets could be responsible for a sizable increase in oil prices.
- The paper recognizes both the consumption and investment aspects of crude oil and proposes Levy processes for modeling uncertainty and options pricing.
- Calibration to crude oil futures' options shows high volatility of oil futures prices, fat-tailed, and right-skewed market expectations, implying a higher probability mass on crude oil prices remaining above the futures' level.
- These findings support the view that demand for futures contracts by investors could lead to excessively high price volatility.
Methodology
- Proposes Levy processes to model uncertainty in crude oil prices and to price options on crude oil futures.
- Calibration conducted to crude oil futures' options (details of calibration procedure are described in the working paper).
Key Findings
- High volatility of oil futures prices is observed in the calibrated models.
- Market expectations are fat-tailed.
- Market expectations are right-skewed, implying a higher probability mass on crude oil prices remaining above the futures' level.
- The behavior of investors’ demand for futures contracts can contribute to excessive price volatility.
Policy and Analytical Implications
- Recognizing crude oil both as a consumption good and as an investable asset is important for understanding price dynamics.
- Derivatives market activity (both speculative and nonspeculative) can materially affect spot and futures price volatility.
- Models that capture fat tails and skewness (such as subordinated Levy processes) provide better characterization of market expectations and risk for option pricing.
Content in this bundle
- Crude oil prices density forecast on July, 5, 2005 for end-September 2005.