# Commodity derivative valuation under a factor model with time-varying market prices of risk

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## Abstract

It is well known that market prices of risk play an important role in commodity derivative valuation. There is an extensive literature showing that market prices of risk vary through time. Based on these results, a factor model, with two long- and short-term factors, with market prices of risk depending on these underlying asset factors is proposed and estimated, using data from crude oil, heating oil, unleaded gasoline and natural gas futures prices traded at NYMEX. The valuation results obtained with an extensive sample of commodity American options traded at NYMEX show that this model with time-varying market prices of risk outperforms standard models with constant market prices of risk.

## Keywords

Market price of risk Commodity prices Commodity derivatives Stochastic processes Kalman filter## JEL Classification

C32 C51 C60 G13## References

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