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Analogy based Valuation of Commodity Options

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  • Siddiqi, Hammad

Abstract

Typically, three types of implied volatility smiles are seen in commodity options: the reverse skew, the smile, and the forward skew. I put forward an economic explanation for all three types of implied volatility smiles based on the idea that a commodity call option is valued in analogy with its underlying futures contract, where the underlying futures price follows geometric Brownian motion. Closed form solutions for commodity calls and puts exist in the presence of transaction costs. Analogy based jump diffusion model is also developed. The smiles are steeper with jump diffusion when compared with smiles with geometric Brownian motion.

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  • Siddiqi, Hammad, 2015. "Analogy based Valuation of Commodity Options," MPRA Paper 61083, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:61083
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    References listed on IDEAS

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    1. Siddiqi, Hammad, 2014. "Analogy Making and the Structure of Implied Volatility Skew," MPRA Paper 60921, University Library of Munich, Germany.
    2. Anders B. Trolle & Eduardo S. Schwartz, 2009. "Unspanned Stochastic Volatility and the Pricing of Commodity Derivatives," The Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4423-4461, November.
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    10. Bates, David S, 1991. "The Crash of '87: Was It Expected? The Evidence from Options Markets," Journal of Finance, American Finance Association, vol. 46(3), pages 1009-1044, July.
    11. Jimmy E. Hilliard & Jorge A. Reis, 1999. "Jump Processes in Commodity Futures Prices and Options Pricing," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 81(2), pages 273-286.
    12. Rockenbach, Bettina, 2004. "The behavioral relevance of mental accounting for the pricing of financial options," Journal of Economic Behavior & Organization, Elsevier, vol. 53(4), pages 513-527, April.
    13. Siddiqi, Hammad, 2009. "Does Coarse Thinking Matter for Option Pricing? Evidence from an Experiment," MPRA Paper 13515, University Library of Munich, Germany.
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    Cited by:

    1. Siddiqi, Hammad, 2015. "Analogy Based Valuation of Currency Options," MPRA Paper 62333, University Library of Munich, Germany.
    2. Siddiqi, Hammad, 2015. "Analogy Based Valuation of Currency Options," Risk and Sustainable Management Group Working Papers 198776, University of Queensland, School of Economics.
    3. Siddiqi, Hammad, 2015. "Relative Risk Perception and the Puzzle of Covered Call Writing," Risk and Sustainable Management Group Working Papers 199882, University of Queensland, School of Economics.
    4. O'Callaghan, Patrick, 2015. "Minimal conditions for parametric continuity of a utility representation," Risk and Sustainable Management Group Working Papers 200371, University of Queensland, School of Economics.
    5. Siddiqi, Hammad, 2015. "Relative Risk Perception and the Puzzle of Covered Call writing," MPRA Paper 62763, University Library of Munich, Germany.

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    More about this item

    Keywords

    Implied Volatility Smile; Implied Volatility Skew; Reverse Skew; Forward Skew; Analogy Making; Commodity Call Option; Commodity Futures Contract;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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