Simulation and Hedging Oil Price with Geometric Brownian Motion and Single-Step Binomial Price Model

Abstract

This paper[1] uses the Geometric Brownian Motion (GBM) to model the behaviour of crude oil price in a Monte Carlo simulation framework. The performance of the GBM method is compared with the naïve strategy using different forecast evaluation techniques. The results from the forecasting accuracy statistics suggest that the GBM outperforms the naïve model and can act as a proxy for modelling movement of oil prices. We also test the empirical viability of using a call option contract to hedge oil price declines. The results from the simulations reveal that the single-step binomial price model can be effective in hedging oil price volatility. The findings from this paper will be of interest to the government of Nigeria that views the price of oil as one of the key variables in the national budget.

JEL Classification Numbers: E64; C22; Q30

Keywords: Oil price volatility; Geometric Brownian Motion; Monte Carlo Simulation; Single-Step Binomial Price Model

[1] Acknowledgement: We wish to thank the two anonymous reviewers for their insightful comments and kind considerations.

Memos to: Azeez Abiola Oyedele, School of Business and Enterprise, University of the West of Scotland, Paisley Campus, Paisley PA1 2BE, Scotland, Email: abiolaoyedele@yahoo.com