Numerical Solution for Mean Reversion with the Drift - One Factor O-U Process

Philip Thomas Date : 18th Oct 2013

Mean Reversion Model

Mean reverting model has been one of the stochastic processes that often used in oil price modelling. The mean reversion is an Ornstein-Uhlenbeck (O-U) process that model the price of commodities like a spring which pulls back the price deviation into the mean. In here, the equations which used in the algorithm will be shown. The notations presented refer to Smith & Mccardle (1999) where they discussed the use of mean reversion model with the drift. The general equation of the mean reverting model in Smith & McCardle (1999) where (t) = ln (p(t)) is : (1)

d (t) = ( (t)) + dz

where denotes the long-run mean to which the log prices revert, describes the strength of mean reversion, describes the volatility of the process and
dz (t) represents increments of a standard brownian motion process.

Refer to Dixit and Pindyck (1994), (t) in equation 1 has

bution

normal distri-

with the mean and variance as follow:

2 2

E [ (t)] = (0)eT + 1 eT V ar[ (t)] = 1 e2T

Numerical Solution
The general discretization of one factor O-U process is given by:
xt = xt1 e
t

+x 1 e

1e

2 t 2

N (0, 1)

where in our case, xt = (t), = . Since we dene (t) = ln (p(t)), then the model should be set to E [p(t)] =
eE [(t)] . However, E [p(t)] = eE [(t)] due to the exponential of a normal dis-

tribution adds the half of the variance in the log-normal distribution mean. Therefore, this is compensated by:
p(t) = exp { (t) 0.5V ar[ (t)]}

By substituting the terms (t) and V ar[ (t)] in the equation above, we can get the solution for sampling the path of non-risk adjusted commodity price:

p(t) = exp ln (p(t 1)) e

+ ln ( p ) 1 e

1e

2 t 2

N (0, 1) 1 e2

2 4

(2) This is the equation that we use in our algorithm.

Input
inputs required in the model are:
t

the discretization time frame that we use in our calculations (e.g., 1 month, 2 months, 6 months, 1 year, etc.)
p

the mean of the price that is revert to within the analysis time frame

standard deviation of our sampling path, which can be calibrated in the further process

the mean reversion rate of our model. This also can be described by Half-Life (H). The denition of half-life is the time that the current price needs to revert half-way to the mean reversion level which can be derived from Eq.1. recall arithmethic O-U: d (t) = ( (t)) dt+ dz where E [d (t)] = ( (t)) dt we take the integration of
(t)=1
d (t) (t)) (t)=0 ( ( (1) ) ( (0) ) d (t) ( (t))

t1
t0

from 0 to 1. We get :

dt

ln

= t

denition of Half-life ( (1) ) = 0.5 ( (0) ) Therefore,

ln(0.5) = H H=
ln(0.5)

as shown in Smith & McCardle (1999)................. Q.E.D