Convenience yield in commodity price modeling: A regime switching approach

Abstract

This paper attempts to model the futures term structures of crude oil and natural gas using the notion of convenience yield in a regime switching framework. Unlike the existing studies, which assume the convenience yield to have either a constant value or to have a stochastic behavior with mean reversion to one equilibrium level, the model of this paper extends the Gibson and Schwartz (1990) model to allow for regime switching in the convenience yield along with the other parameters. A closed form solution for the futures price is derived and the model parameters are estimated using the maximum likelihood method. The results show that the estimated regimes are very close to the contango and backwardation regimes commonly seen in futures markets. The results also show that the transitional probabilities play an important role in shaping the futures term structure implied by the model.