Evaluation of different stochastic processes for the convenience yield for crude oil

Adriaan Krul

Site of the project:
ING Bank
Foppingadreef 7
1102 BD Amsterdam

start of the project: December 2007

In February 2008 the Interim Thesis has been appeared and a presentation has been given.

The Master project has been finished in July 2008 by the completion of the Masters Thesis and a final presentation has been given.

For working address etc. we refer to our alumnipage.

Summary of the master project:

Nowadays, traders calibrate the so-called convenience yield (CY) via market data every two days, using the forward price. The convenience yield is the benefit or premium associated with holding an underlying product or physical good. Sometimes, due to irregular market movements such as an inverted market, the holding of an underlying good or security may become more profitable than owning the contract or derivative instrument, due to its relative scarcity versus high demand. An example would be purchasing physical bales of oil rather than future contracts. Should there be a sudden drought and the demand for oil increases, the difference between the first purchase price of the oil versus the price after the shock would be the convenience yield. This is seen in the market nowadays.

The market shows however that the CY behaves stochastically and has a mean-reversion property. In the literature the CY often follows an Ornstein-Uhlenbeck process and is then calculated by means of a Kalman filter. The disadvantage of this process is that the CY can become negative which can result in cost and carry arbitrage possibilities. If the CY follows a CIR model the negativity is not present. Again the CY is calculated by means of the Kalman filter. All results are applied on the crude oil market from a data set of three years. The aim of this project is to implement the Kalman filter and to numerically test both stochastic processes on the crude oil data and compare the results. After this a third, novel, process will be developed with the same properties (i.e. mean-reversion).

The contents of one barrel of crude oil

Market data for crude oil

Contact information: Kees Vuik

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