Closed Form Approximations for Spread Options
AbstractThis article expresses the price of a spread option as the sum of the prices of two compound options. One compound option is to exchange vanilla call options on the two underlying assets and the other is to exchange the corresponding put options. This way we derive a new closed form approximation for the price of a European spread option and a corresponding approximation for each of its price, volatility and correlation hedge ratios. Our approach has many advantages over existing analytical approximations, which have limited validity and an indeterminacy that renders them of little practical use. The compound exchange option approximation for European spread options is then extended to American spread options on assets that pay dividends or incur costs. Simulations quantify the accuracy of our approach; we also present an empirical application to the American crack spread options that are traded on NYMEX. For illustration, we compare our results with those obtained using the approximation attributed to Kirk (1996, Correlation in energy markets. In: V. Kaminski (Ed.), Managing Energy Price Risk, pp. 71--78 (London: Risk Publications)), which is commonly used by traders.
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Bibliographic InfoArticle provided by Taylor and Francis Journals in its journal Applied Mathematical Finance.
Volume (Year): 18 (2011)
Issue (Month): 5 (January)
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Web page: http://taylorandfrancis.metapress.com/link.asp?target=journal&id=100141
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- Elisa Alòs & Jorge A. León, 2012. "On the goodness of fit of Kirk's formula for spread option prices," Economics Working Papers 1347, Department of Economics and Business, Universitat Pompeu Fabra.
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