Commodity Price Dynamics: A Structural Approach

by Craig Pirrong

• ISBN13: 9780521195898
• ISBN10: 0521195896
• Format: Hardcover
• Copyright: 2011-10-31
• Publisher: Cambridge University Press

Summary

Commodities have become an important component of many investors' portfolios and the focus of much political controversy over the past decade. This book utilizes structural models to provide a better understanding of how commodities' prices behave and what drives them. It exploits differences across commodities and examines a variety of predictions of the models to identify where they work and where they fail. The findings of the analysis are useful to scholars, traders, and policy makers who want to better understand often puzzling - and extreme - movements in the prices of commodities from aluminum to oil to soybeans to zinc.

Author Biography

Craig Pirrong is Professor of Finance and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business at the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University and a faculty member at the University of Michigan, the University of Chicago, and Washington University. Professor Pirrong's research focuses on commodities and commodity derivative pricing, the relation between market fundamentals and commodity price dynamics and the implications of this relation for the pricing of commodity derivatives, derivatives market regulation, commodity market manipulation, and the organization of commodity markets. He has published more than thirty-five articles in professional publications and is the author of four books. He has consulted widely with financial exchanges around the world, testified before Congress on energy pricing, and served as an expert witness in a variety of cases involving commodity markets. He holds a Ph.D. in business economics from the University of Chicago.

Table of Contents

Preface	p. ix
Introduction	p. 1
Introduction	p. 1
A Commodity Taxonomy	p. 4
Commodity Markets and Data	p. 6
An Overview of the Remainder of the Book	p. 8
Modeling Storable Commodity Prices	p. 9
A Two-Factor Model of a Continuously Produced Commodity	p. 9
The Empirical Performance of the Two-Factor Model	p. 10
Commodity Pricing with Stochastic Fundamental Volatility	p. 10
The Pricing of Seasonally Produced Commodities	p. 11
The Pricing of Pollution Credits	p. 11
Non-Storable Commodities Pricing: The Case of Electricity	p. 12
Where This Book Fits in the Literature	p. 12
The Basics of Storable Commodity Modeling	p. 18
Introduction	p. 18
Dynamic Programming and the Storage Problem: An Overview	p. 20
Model Overview	p. 20
Competitive Equilibrium	p. 22
The Next Step: Determining the Forward Price	p. 24
Specifying Functional Forms and Shock Dynamics	p. 27
A More Detailed Look at the Numerical Implementation	p. 30
Solving a PDE Using Finite Differences: The One-Dimensional Case	p. 36
Solving the 2D PDE	p. 39
Boundary Conditions	p. 40
Summary	p. 42
High-Frequency Price Dynamics for Continuously Produced Commodities in a Two-Factor Storage Economy: Implications for Derivatives Pricing	p. 44
Introduction	p. 44
A Model of the Storage Economy with a Continuously Produced Commodity	p. 47
Introduction	p. 47
Framework and Numerical Solution	p. 47
Moments and the State Variables	p. 49
Derivatives Pricing	p. 54
Extension: Storage Capacity Constraints	p. 65
Extension: The Effects of Speculation on Price Dynamics in the Storage Economy	p. 67
Summary and Conclusions	p. 71
The Empirical Performance of the Two-Factor Storage Model	p. 73
Introduction	p. 73
Empirical Tests of the Theory of Storage: A Brief Literature Review	p. 75
An Alternative Empirical Approach	p. 77
Overview	p. 77
The Extended Kalman Filter	p. 80
Parameter Choices and Data	p. 83
Results	p. 84
The Implications of the Model for the Speculation Debate	p. 100
Summary and Conclusions	p. 107
Stochastic Fundamental Volatility, Speculation, and Commodity Storage	p. 109
Introduction	p. 109
Speculation and Oil Prices	p. 114
The Storage Economy	p. 116
Equilibrium Competitive Storage	p. 118
Solution of the Storage Problem	p. 119
Results: Storage, Prices, and Spreads	p. 120
Results: The Time Series Behavior of Prices, Stocks, and Volatility	p. 124
Some Other Empirical Evidence	p. 126
Conclusions	p. 128
The Pricing of Seasonal Commodities	p. 131
Introduction	p. 131
The Model	p. 134
Results	p. 137
Empirical Evidence	p. 145
Alternative Explanations for the Empirical Regularities	p. 152
Preferences	p. 152
Inventories as a Factor of Production	p. 155
Multiple Storable Commodities	p. 157
Summary and Conclusions	p. 162
The Dynamics of Carbon Markets	p. 164
Introduction	p. 164
The Model	p. 166
Results	p. 170
Summary	p. 178
The Structural Modeling of Non-Storables: Electricity	p. 181
Introduction	p. 181
Electricity Markets	p. 183
A Structural Model for Pricing Electricity Derivatives	p. 185
Model Implementation	p. 194
Commonly Traded Power Options	p. 198
Daily Strike Options	p. 198
Monthly Strike Options	p. 199
Spark Spread Options	p. 199
Valuation Methodology	p. 200
Daily Strike and Monthly Strike Options	p. 200
Spark Spread Options	p. 201
Results	p. 202
Complications	p. 211
Summary and Conclusions	p. 214
References	p. 217
Author Index	p. 221
Subject Index	p. 223
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