Modeling Commodity Prices under the CEV Model

Abstract

Deregulation of energy commodity markets in the last decade, together with the growth of world consumption and the attractive returns on commodities over the period 2000-2007, has generated a dramatic increase in trading volumes and, in turn, spikes and random changes in the volatility of commodity spot prices. This article introduces the constant elasticity of variance (CEV) model for commodity prices and examines its calibration to four strategic commodity trajectory prices over the period 1990-2007 by using a Generalized Method of Moments. Six other models are compared to the CEV model by performing a test of goodness-of-fit. Estimating the model for crude oil, coal, copper, and gold and comparing the results during the sub-periods 1990-1999 and 2000-2007 shows that the constant elasticity of variance exponent can efficiently account for the stochastic volatility observed after 2000 in commodity prices. Moreover, the article exhibits that although mean-reverting processes well captured the pattern of commodity prices prevailing before 2000, they do not apply to the recent past.

TOPICS: Commodities, statistical methods, financial crises and financial market history