Pricing Partners upgrades commodity module

Source: Pricing Partners

Pricing Partners, the independent valuation expert and a world leader in mathematical models and analytics for derivatives and structured products, announced todaya significant progress in its existing commodity module with the release of the Gabillon and Gibson Schwartz model.

With this new upgrade on commodity module, Pricing Partners significantly enhances its authority on cutting edge model expertise.

Learning lessons from the crisis with the unprecedented level of volatility on commodity derivatives, fast futures curve reshaping from backwardation to more standard contango and increased scrutiny on accurate valuation, Pricing Partners quantitative research team spent considerable efforts to optimize this module. With this improved module, Pricing Partners is now able to better calibrate and price a wide range of commodity related derivatives.

Two models have been added and particularly stood out: Gabillon model and Gibson Schwartz model, identified as market standard two-factor models specific to the commodity market and able to capture future curve movement. Indeed, these two models consider that the convenience yield itself follows a stochastic process correlated to the spot process. This stochastic convenience yield provides a much better forward dynamic compared to Black Scholes, local volatility or more generally any other deterministic convenience yield model as they take into account the risk of futures curve reshaping changing from backwardation to contango situation and vice versa.

For the two models, Pricing Partners implemented not only analytical formulas for futures and vanilla options allowing fast analytical calibration but also numerical compatibility with its generic Monte Carlo and PDE engine. Key differences in the two models are that the Gibson Schwartz model, widely used in the commodity market, assume stochastic convenience yield per se while the Gabillon model introduces indirectly stochastic convenience yield by means of a "long term price" concept that may be very natural in certain commodity market with strong mean reversion property.

Mr. Zaizhi Wang, financial engineer at Pricing Partners, comments: "The improved module taking into consideration both Gibson Schwartz and Gabillon models enables us a better modeling of the dynamic of the convenience yield. We have seen unprecedented level of curve reshaping like for instance on the crude oil market where the spot price went up to more than 140 dollars a barrel up to a current 70 dollar while the long term futures did not move as fast reshaping considerably the futures curve. It made sense for us to have proper models to account for fast curve reshaping to price commodity accurate. This new development is obviously much more accurate on products sensitive to the stochasticity of the convenience yield, and already concerns simple products like options on futures."

Mr. Eric Benhamou, CEO of Pricing Partners adds: "The commodity market has become a major asset class especially with all the eyes focusing on the exploding commodities prices (crude oil, metal and agricultural goods) and the corresponding options market. Now that the Price-it library has reached a certain maturity level with becoming recently the world wide largest library in terms of asset class coverage, we are focusing on more accuracy on topical topics. Commodity is definitely one of our centers of attention."

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