Stochastic Models for Oil Prices and the Pricing of Futures on Oil

Abstract

In this article, we investigate and compare the performance of various one-factor diffusion models in their ability to capture the behaviour of Brent crude oil prices. New proposed models, which have a three-quarters power in the diffusion term, are found to outperform all other popular models tested. Analytic solutions for futures prices under the new models are found and used to calibrate market prices. Results from the calibration show that one of the new three-quarters models with a mean-reverting property outperforms other popular models in fitting and forecasting futures prices.

Key Words:

• Stochastic models
• oil prices
• futures on oil

Acknowledgement

Mohammed Aba Oud gratefully acknowledges Al Imam Mohammad Ibn Saud Islamic University for the awarding of a PhD scholarship.