Financial Derivative and Energy Market Valuation: Theory and Implementation in MATLAB

Chapter 10: Short-Term Deviation/Long-Term Equilibrium Model

10.1 Introduction

Schwartz and Smith (2000) developed a two-factor model on the basis of an equilibrium price and a short-term deviation from this equilibrium price. This model marked a transition away from the convenience yield concept. Although the idea of convenience yield is intellectually satisfying and useful for economic analysis, a convenience yield cannot be directly measured. Some attempts to link the inventory levels to a theoretical convenience yield and then to the price have been successful (Villaplana, 2004). Despite the merit of this approach, this linkage reveals a major issue with the convenience yield. Both the price and convenience yield are highly correlated to inventory levels. Therefore, the price and convenience yield are far from orthogonal to each other. In general, proper fitting and forecasting with a model requires nearly orthogonal parameters. It is interesting to note that Schwartz and Smith (2000) did prove that the equilibrium price and short-term parameters can be related to the convenience yield model parameters. If futures contract valuation is the main impetus, then the convenience yield is not needed.

10.2 Schwartz and Smith Model

The equilibrium price is dependent on factors that affect ...