Analytic Approximations for Spread Options
AbstractEven in the simple case that two price processes follow correlated geometric Brownian motions with constant volatility no analytic formula for the price of a standard European spread option has been derived, except when the strike is zero in which case the option becomes an exchange option. This paper expresses the price of a spread option as the price of a compound exchange option and hence derives a new analytic approximation for its price and hedge ratios. This approximation has several advantages over existing analytic approximations, which have limited validity and an indeterminacy that renders them of little practical use. Simulations quantify the accuracy of our approach and demonstrate the indeterminacy and inaccuracy of other analytic approximations. The American spread option price is identical to the European option price when the two price processes have identical drifts, and otherwise we derive an expression for the early exercise premium. A practical illustration of the model calibration uses market data on American crack spread options.
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Bibliographic InfoPaper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2007-11.
Length: 25 pages
Date of creation: Aug 2007
Date of revision:
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More information through EDIRC
Asset pricing; Spread options; Exchange options; American Options;
Other versions of this item:
- C02 - Mathematical and Quantitative Methods - - General - - - Mathematical Economics
- C29 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Other
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Li, Minqiang, 2008. "Closed-Form Approximations for Spread Option Prices and Greeks," MPRA Paper 6994, University Library of Munich, Germany.
- Emmanuel Hanert & Aanand Venkatramanan, 2008. "Meshfree Approximation for Multi-Asset Options," ICMA Centre Discussion Papers in Finance icma-dp2009-07, Henley Business School, Reading University, revised Jun 2009.
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