On the calibration of the Schwartz two-factor model to WTI crude oil options and the extended Kalman Filter

Ewald, C.-O. , Zhang, A. and Zong, Z. (2019) On the calibration of the Schwartz two-factor model to WTI crude oil options and the extended Kalman Filter. Annals of Operations Research, 282(1-2), pp. 119-130. (doi: 10.1007/s10479-018-2770-x)

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The Schwartz (J Finance 52(3):923–973, 1997) two factor model serves as a benchmark for pricing commodity contracts, futures and options. It is normally calibrated to fit the term-structure of a range of future contracts with varying maturities. In this paper, we investigate the effects on parameter estimates, if the model is fitted to prices of options, with varying maturities and strikes instead of futures, as is commonly done. The use of option prices rather than futures in the calibration leads to non-linearities, which the standard Kalman filter approach is unable to cope with. To overcome these issues, we use the extended Kalman Filter. We find that some parameters sensitively depend on the choice of strikes of the corresponding options, and are different from those estimates obtained from using futures prices. This effect is analogue to varying implied volatilities in the Black–Scholes model. This realization is important, as the use of ill-fitted models for pricing options in the Schwartz (1997) framework may cause traders to bear serious financial losses.

Item Type:Articles
Glasgow Author(s) Enlighten ID:Ewald, Professor Christian and Zong, Zhe
Authors: Ewald, C.-O., Zhang, A., and Zong, Z.
College/School:College of Social Sciences > Adam Smith Business School > Economics
Journal Name:Annals of Operations Research
ISSN (Online):1572-9338
Published Online:31 January 2018
Copyright Holders:Copyright © 2018 The Authors
First Published:First published in Annals of Operations Research 282(1-2): 119-130
Publisher Policy:Reproduced under a Creative Commons License

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