ABSTRACT
Black (1976) advocated the idea of trading commodities as ‘equities without dividends’ and made use of geometric Brownian motion. However, given the complexity of the shapes associated with the term structure of commodities futures, the simple geometric Brownian motion model proposed by Black (1976) is not a good t. To resolve this problem, mean reversion has been introduced. Unlike equities, when commodities prices rise, there is generally (albeit with a time lag) an increase in supply; conversely, when prices decline, supply decreases. e fact that prices are determined by the supply and demand balance means that the supply side adjusts supply volumes, which has the eect of constraining the potential for commodities prices to move in a single direction. at is why it is generally considered appropriate to employ mean reversion in commodity pricing models. Much empirical research has been carried out on this subject. For example, it was veried by Bessembinder et al. (1995).
