Distributed Slides

Motivation
A concrete model
Suitability for different commodities
Interaction with other assets
A Generic Commodities Model?:

Is a model for crude any use for coffee and
copper?
Alan Stacey
Nomura International plc
ICBI Global Derivatives, Paris

13th April 2011
Alan Stacey Commodities Modelling

Motivation
A concrete model
Motivation
A concrete model
Specifying the model
Semi-analytic approximation examples

Calibrating the model
Measures of two-factorness
Accuracy of calibration
Other single commodity modelling idiosyncrasies

Motivation
A concrete model
Commodities Exotics
This is about dynamic models suitable for pricing and risk

management of structures such as:
I APOs (asian options)
I Barrier options and other autocallables e.g. TARS.
I Extendible swaps (callables)
I Basket options
I compo options and quantos
I barriers on worst-ofs (or, sometimes equivalently, best-ofs)
I More complex structured notes

Motivation
A concrete model
Why a distinct asset class?
Many of these products are most common to particular

underlyings, e.g. gold, WTI crude, sugar; but they exist with
virtually any exchange-traded commodity: its impossible to design
a separate model for every one
Commodities have characteristics which make their modelling
distinct from that of rates, equities, FX, credit...
I Scale-invariance with roughly log-normal evolution
I Can have pronounced skew in either direction
I Need to model dynamics of a curve with at least 2-3
significant principal components
I Other features common to some commodities, e.g.
seasonality.

Motivation
A concrete model Specifying the model
Suitability for different commodities Semi-analytic approximation examples
The Jar Kai model
I We will just a particular production model I developed at

Nomura to illustrate the issues.
I Can give basic equations and intuition but not all the
implementation details for reasons of time.
I There are various enhancements to the model to handle
particular issues which I cant go into.

Motivation
Model definition
Let F (t, T ) be the price at time t of the future expiring at time T .

For the usual daily margined futures this must be a martingale in
the rolling money market account measure.
I We define dF (t,T )
F (t,T ) in terms of two SABR processes, one of
which drives the whole futures curve in parallel and the other
of which only drives the short end of the curve.
(Exact form of the equations omitted from this version of the
slides.)

Motivation
Model properties
This definition has some obvious desirable properties.

I Two-factor behaviour: instantaneous correlation of different
parts of the futures curve is not 1.
I Volatility and intra-curve decorrelation tend to decrease with
time to expiry .
I Allows for skew/smile
I Permits a term structure of inter-curve correlation
I Scale-free (lognormal-type) behaviour.
But why exactly this form?

Motivation
Why exactly this form?

For example, why not a principal component analysis?
In rates it is common to propose a functional form for intra-curve
correlations (usually one that is theoretically impossible!), fit to
historical data, then take the leading principal components to get a
reduced factor model.
If one did this for commodities, the two leading components would
typically look something like our two components (once
orthogonalized) - this suggest the dynamics are realistic.
But Jar Kai, with stochastic volatility is tractable.
I We can take long (6M or 1Y) steps with virtually no loss of
accuracy.
I We have a semi-analytic approximation for Europeans
sufficiently accurate out to 3-5 years for calibration.

Motivation
WTI crude - 2Y expiry

Motivation

Motivation

Motivation
Sugar - 1Y expiry
Positive skew presented significant extra challenges to prevent
blow-up.

Motivation
Sugar - 3.5Y expiry

Motivation Calibrating the model
A concrete model Measures of two-factorness
Suitability for different commodities Accuracy of calibration
Interaction with other assets Other single commodity modelling idiosyncrasies
Measure suitability
Various measures of suitability

I Are the local dynamics reasonable? Most obvious example of
unsuitability is power.
I Are key features neglected? e.g. seasonality.
I Does the model calibrate well to the market?

Calibration Instruments
Exchanges publish, at least daily, prices for options for many

different strikes per futures contract (usually only one expiry,
shortly before that of the future itself).
The Jar Kai model has nine main parameters (plus kT s to
fine-tune the ATM volatilities). One approach is to throw all the
option prices into the pot and use a least-squares optimizer.
Indeed, some people do this. But it is very unstable.

Intra-curve correlations
I Intra-curve correlations are very important and vary

dramatically with changes in parameters, mainly 2 and .
I However options prices do not vary much with 2 and , or
more precisely the option price fitting accuracy depends only
very weakly on 2 and .
I So we need to pin down intra-curve correlatons (and hence 2
and ) more directly.
I There are no liquid instruments to do this. (Brokers quotes
can sometimes be obtained for calendar spreads in very deep
markets like WTI).
I We use historical correlations.

Two-factor models have obvious correlation restrictions
Orthogonalizing our instantaneous futures drivers to X and Y , at a

given instant we may write, for any futures expiry T ,
dF T = T (cos T dX + sin T dY ) .
Then corr(dF T , dF S ) = cos(T S ).

Given expiries T1 < T2 < T3 , writing corr(dF Ti , dF Tj ) = cos(ij ),
we have
13 = 12 + 23 .

Calibrating the intra-curve correlations
For a more general case (i..e, not arising from a two-factor model)
we have
13 12 + 23 .
This is an easy exercise mathematically, and also has a
straightforward heuristic explanation.
We calibrate by taking three reasonably liquid tenors, e.g. 3M, 1Y,
3Y (commodity dependent) and then massaging the three pairwise
correlations so this inequality becomes an equality. We then
calibrate to fit these correlations.
How far this inequality deviates from equality is a good measure of
two-factorness.

Brent
Tenor Pair Hist. Corr. Angle Two-factor Product

6M1Y 99.3% 0.1184
1Y2Y 99.1% 0.1342
6M2Y 97.1% 0.2414 96.8% 98.4%

1M6M 99.0% 0.1415
6M2Y 97.1% 0.2414
1M2Y 94.6% 0.3301 92.8% 96.1%
WTI is more idiosyncratic than Brent, with a behaviour further
from a two-factor model. Why?

Aluminium

6M1Y 99.9% 0.0447
1Y2Y 99.4% 0.1095
6M2Y 98.9% 0.1485 98.8% 99.3%

1M6M 99.8% 0.0633
6M2Y 98.9% 0.1485
1M2Y 98.3% 0.1847 97.8% 98.7%

Sugar

6M12M 97.0% 0.244
12M17M 98.4% 0.180
6M17M 94.0% 0.348 91.1% 95.4%

Quality of intra-curve correlation fit
The calibration matches the intra-curve correlations exactly, is

ultimately fine-tuned using the kT s to match the ATM volatilities
precisely too, and fits other input option prices as well as possible
using a least-squares optimizer (this glosses over some tricky
details).
But one can still ask how good is the intra-curve fit. If is poor then
we can seem some extreme parameters which mean that
I Intra-curve correlations other than those input are not
well-fitted.
I Approximations which we rely on in simulation and calibration
are stretched to their limits .

Calibrated Jar Kai parameters I

WTI Calibration
Sugar Calibration

Calibrated Jar Kai parameters II

Copper Calibration
Aluminium Calibration

Smile fitting - Copper 1M

Smile fitting - Copper 10M

Smile fitting - Copper 4Y

Smile fitting - Sugar 3M

Smile fitting - Sugar 20M

Smile fitting - WTI 3M

Smile fitting - WTI 10M

Smile fitting - WTI 5Y

Calibration Summary
We see that the model calibrates poorly if:

I The intra-curve decorrelation does not decay steadily with
expiry. Usually this occurs when the correlations are very high
at the short end.
I The smile has a lot of idiosyncratic structure.
I We need to fit the very short-dated smile accurately (while
maintaining vol-vol parameters that can be used at longer
maturities). Mean-reverting volatility performs better but is
harder. Jumps would be even better (as we all know).

Special treatment is needed for certain commodities

Seasonality has various manifestations.
I Gas is hard to store and more expensive in the winter than the
summer. This is reflected in the forward curve and causes no
difficulty.
I Gas and some other fuels are prone to supply shortages in the
winter making them more volatile. The model can fit this (via
the kT s) but will try not to - it is under strain.
I Correlation between agricultural futures drops sharply across a
harvest. The model, with a time-homogeneous correlation
structure, cannot reflect this at all.
Precious metals, especially gold, trade in many ways like FX.
Standard FX-type barrier products on Gold will have tight prices
derived using PDE methods than this model cannot reproduce.
But for mixed-commodity baskets we dont have anything better.
Motivation
A concrete model
Products referencing a commodity and another asset
So far we have only considered how well the model suits products
referencing a single commodity. But often we care about the
interaction between a commodity and another asset.
I quantos/compos - FX rates
I callables with a funding leg - interest rates
I baskets/worst-ofs - another commodity
As an illustration, we will consider the interaction between two
commodities.

Motivation
A concrete model
Inter-commodity correlation
Simple models tend to assume that the correlation between two
commodities can be expressed by a single number.
Often this is the historical correlation between the spot or 1nb
(prompt contract) prices as these are most liquid.
But this can be very different from the correlation between long
ends of the curve.
Commodity 1 Commodity 2 Short-end corr 2Y Corr
Aluminium Soybeans 42% 49%
Aluminium Brent 53% 59%
Aluminium Gold 14% 24%
Soybeans Brent 36% 60%
Soybeans Gold 0.5% 57%
Brent Gold 33% 45%
A similar picture emerges even within commodities of the same
general class, e.g. agriculturals, softs, base metals.
Motivation
A concrete model
Several inter-curve correlations from one data point?
An even richer picture is needed if we care about long-short

cross-commodity correlations.
The Jar Kai model is rich enough to have enough cross-factor
correlations to fit several inter-curve correlations. However,
sometimes it is necessary to make a heroic attempt to infer these
from just the short-end correlation. There is enough consistency of
behaviour between commodities to produce good results ... most
of the time!

Motivation
A concrete model
Alumininum-Soybean
Table: Model prediction

short long
short 42.3% 53.5%
long 43.0% 54.5%
Table: Actual historicals

short long
short 42.3% 50.1%
long 40.7% 48.8%

Motivation
A concrete model
Alumininum-Brent

short long
short 53% 58%
long 54% 59%

short long
short 53% 59%
long 51% 59%

Motivation
A concrete model
Brent-Gold

short long
short 33% 34%
long 36% 37%

short long
short 33% 48%
long 31% 45%
Gold follows a qualitatively different pattern from everything else.


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Motivation

A Generic Commodities Model?:

Nomura International plc

ICBI Global Derivatives, Paris

Alan Stacey Commodities Modelling

Suitability for different commodities

Interaction with other assets

Alan Stacey Commodities Modelling

This is about dynamic models suitable for pricing and risk

Alan Stacey Commodities Modelling

Why a distinct asset class?

Many of these products are most common to particular

Alan Stacey Commodities Modelling

The Jar Kai model

I We will just a particular production model I developed at

Alan Stacey Commodities Modelling

Let F (t, T ) be the price at time t of the future expiring at time T .

Alan Stacey Commodities Modelling

This definition has some obvious desirable properties.

Alan Stacey Commodities Modelling

Why exactly this form?

Alan Stacey Commodities Modelling

WTI crude - 2Y expiry

Alan Stacey Commodities Modelling

WTI crude - 4Y expiry

Alan Stacey Commodities Modelling

WTI crude - 6Y expiry

Alan Stacey Commodities Modelling

Alan Stacey Commodities Modelling

Sugar - 3.5Y expiry

Alan Stacey Commodities Modelling

Various measures of suitability

Alan Stacey Commodities Modelling

Exchanges publish, at least daily, prices for options for many

Alan Stacey Commodities Modelling

I Intra-curve correlations are very important and vary

Alan Stacey Commodities Modelling

Two-factor models have obvious correlation restrictions

Orthogonalizing our instantaneous futures drivers to X and Y , at a

Then corr(dF T , dF S ) = cos(T S ).

Alan Stacey Commodities Modelling

Calibrating the intra-curve correlations

Alan Stacey Commodities Modelling

Tenor Pair Hist. Corr. Angle Two-factor Product

Tenor Pair Hist. Corr. Angle Two-factor Product

Alan Stacey Commodities Modelling

Tenor Pair Hist. Corr. Angle Two-factor Product

Tenor Pair Hist. Corr. Angle Two-factor Product

Alan Stacey Commodities Modelling

Tenor Pair Hist. Corr. Angle Two-factor Product

Alan Stacey Commodities Modelling

Quality of intra-curve correlation fit

The calibration matches the intra-curve correlations exactly, is

Alan Stacey Commodities Modelling

Calibrated Jar Kai parameters I

Alan Stacey Commodities Modelling

Calibrated Jar Kai parameters II

Alan Stacey Commodities Modelling

Smile fitting - Copper 1M

Alan Stacey Commodities Modelling

Smile fitting - Copper 10M

Alan Stacey Commodities Modelling

Smile fitting - Copper 4Y

Alan Stacey Commodities Modelling