Risk Management in Commodity Markets: From Shipping to Agriculturals and Energy

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Structural Models of Commodity Prices

Craig Pirrong

1.1 INTRODUCTION

The transparency of fundamentals in commodity markets (in contrast to equity or currency markets, for instance) holds out the promise of devising structural models of commodity price behavior that can illuminate the underlying factors that drive these prices, and which perhaps can be used to value contingent claims on commodities. There has been much progress on these models in recent years, but the empirical data show that real-world commodity price behavior is far richer than that predicted by the current generation of models, and that except for non-storable commodities, structural models currently cannot be used to price derivatives. The models and empirical evidence do, however, point out the deficiencies in reduced form commodity derivative pricing models, and suggest how reduced form models must be modified to represent commodity price dynamics more realistically. They also suggest additional factors that may be added to the models (at substantial computational cost) to improve their realism.

This chapter sketches out the current state of fundamental models of commodity markets. It starts with a taxonomy of commodities, and then proceeds to discuss models for storable and non-storable commodities, and structural models for each.

1.2 A COMMODITY TAXONOMY

Although the catchall term “commodity” is widely applied to anything that is not a true asset, it conceals tremendous diversity, diversity that has material ...