Time-varying Long-run Mean of Commodity Prices and the Modeling of Futures Term Structures

The exploitation of the mean-reversion of commodity prices is important for inventory management, in‡ation forecasting and contingent claim pricing. Bessembinder, Coughenour, Seguin and Smoller (1995) document the mean-reversion of commodity spot prices using futures term structure data; however, mean-reversion to a constant level is rejected in nearly all studies using historical spot price time series. This indicates that the spot prices revert to a stochastic long-run mean. By recognizing this, I propose a reduced-form model with the stochastic long-run mean as a separate factor. This model …ts the futures dynamics better than do classical models such as the Gibson-Schwartz (1990) model and the Casassus-CollinDufresne (2005) model with a constant interest rate. An application for option pricing is also presented in this paper. Please address any comments to Ke Tang, 512D Mingde Building, Renmin University of China, Beijing, 100872. Tel:+86 10 62519408; Email:[email protected]. I am grateful to two anonymous referees, whose comments and suggestions have greatly improved this paper.