A Two-Factor Model for Commodity Prices and Futures Valuation

This paper develops a reduced form two-factor model for commodity spot prices and futures valuation. This model extends the Gibson and Schwartz (1990)-Schwartz (1997) two-factor model by adding two new features. First the Ornstein-Uhlenbeck process for the convenience yield is replaced by a Cox-Ingersoll-Ross (CIR) pro- cess. This ensures that our model is arbitrage-free. Second, spot price volatility is proportional to the square root of the convenience yield level. We empirically test both models using weekly crude oil futures data from 17We would like to thank Elizabeth Whalley and Mathias Muck for their helpful comments. Earlier