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Subordinated Levy Processes and Applications to Crude Oil Options

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Author Info
Noureddine Krichene
Abstract

One approach to oil markets is to treat oil as an asset, besides its role as a commodity. Speculative and nonspeculative activity by investors in the derivatives markets could be responsible for a sizable increase in oil prices. This paper recognizes both the consumption and investment aspects of crude oil and proposes Levy processes for modeling uncertainty and options pricing. Calibration to crude oil futures' options shows high volatility of oil futures prices, fat-tailed, and right-skewed market expectations, implying a higher probability mass on crude oil prices remaining above the futures' level. These findings support the view that demand for futures contracts by investors could lead to excessively high price volatility.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 05/174.

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Length: 26 pages
Date of creation: 14 Sep 2005
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Handle: RePEc:imf:imfwpa:05/174

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  1. Peter Carr & Helyette Geman, 2002. "The Fine Structure of Asset Returns: An Empirical Investigation," Journal of Business, University of Chicago Press, vol. 75(2), pages 305-332, April. [Downloadable!]
  2. Merton, Robert C., 1976. "Option pricing when underlying stock returns are discontinuous," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 125-144. [Downloadable!] (restricted)
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  3. Black, Fischer & Scholes, Myron S, 1973. "The Pricing of Options and Corporate Liabilities," Journal of Political Economy, University of Chicago Press, vol. 81(3), pages 637-54, May-June. [Downloadable!] (restricted)
  4. Frank Milne & Dilip Madan, 1991. "Option Pricing With V. G. Martingale Components," Working Papers 1159, Queen's University, Department of Economics. [Downloadable!]
  5. Alan L. Lewis, 2001. "A Simple Option Formula for General Jump-Diffusion and other Exponential Levy Processes," Related articles explevy, Finance Press. [Downloadable!]
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