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Long term spread option valuation and hedging

  • Dempster, M.A.H.
  • Medova, Elena
  • Tang, Ke
Registered author(s):

This paper investigates the valuation and hedging of spread options on two commodity prices which in the long run are in dynamic equilibrium (i.e., cointegrated). The spread exhibits properties different from its two underlying commodity prices and should therefore be modelled directly. This approach offers significant advantages relative to the traditional two price methods since the correlation between two asset returns is notoriously hard to model. In this paper, we propose a two factor model for the spot spread and develop pricing and hedging formulae for options on spot and futures spreads. Two examples of spreads in energy markets - the crack spread between heating oil and WTI crude oil and the location spread between Brent blend and WTI crude oil - are analyzed to illustrate the results.

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File URL: http://www.sciencedirect.com/science/article/B6VCY-4SBHX2F-2/2/3962607bae441d10b2f7ad6a50212486
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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 32 (2008)
Issue (Month): 12 (December)
Pages: 2530-2540

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Handle: RePEc:eee:jbfina:v:32:y:2008:i:12:p:2530-2540
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  1. Bryan R. Routledge & Duane J. Seppi & Chester S. Spatt, 2000. "Equilibrium Forward Curves for Commodities," Journal of Finance, American Finance Association, vol. 55(3), pages 1297-1338, 06.
  2. Richter, Martin & Sørensen, Carsten, 2002. "Stochastic Volatility and Seasonality in Commodity Futures and Options: The Case of Soybeans," Working Papers 2002-4, Copenhagen Business School, Department of Finance.
  3. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-80, November.
  4. Allan w. Gregory & Bruce E. Hansen, 1992. "residual-Based Tests for Cointegration in Models with Regime Shifts," Working Papers 862, Queen's University, Department of Economics.
  5. Fama, Eugene F & French, Kenneth R, 1988. "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, University of Chicago Press, vol. 96(2), pages 246-73, April.
  6. Bates, David S, 1996. "Jumps and Stochastic Volatility: Exchange Rate Processes Implicit in Deutsche Mark Options," Review of Financial Studies, Society for Financial Studies, vol. 9(1), pages 69-107.
  7. Geman, Hélyette, 2005. "Energy Commodity Prices : Is Mean-reversion Dead ?," Economics Papers from University Paris Dauphine 123456789/1442, Paris Dauphine University.
  8. Paul Berhanu Girma & Albert S. Paulson, 1999. "Risk arbitrage opportunities in petroleum futures spreads," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 19(8), pages 931-955, December.
  9. Gibson, Rajna & Schwartz, Eduardo S, 1990. " Stochastic Convenience Yield and the Pricing of Oil Contingent Claims," Journal of Finance, American Finance Association, vol. 45(3), pages 959-76, July.
  10. Eduardo Schwartz & James E. Smith, 2000. "Short-Term Variations and Long-Term Dynamics in Commodity Prices," Management Science, INFORMS, vol. 46(7), pages 893-911, July.
  11. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
  12. Hull, John & White, Alan, 1990. "Pricing Interest-Rate-Derivative Securities," Review of Financial Studies, Society for Financial Studies, vol. 3(4), pages 573-92.
  13. Les Clewlow & Chris Strickland, 1999. "Valuing Energy Options in a One Factor Model Fitted to Forward Prices," Research Paper Series 10, Quantitative Finance Research Centre, University of Technology, Sydney.
  14. Hilliard, Jimmy E. & Reis, Jorge, 1998. "Valuation of Commodity Futures and Options under Stochastic Convenience Yields, Interest Rates, and Jump Diffusions in the Spot," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(01), pages 61-86, March.
  15. Margrabe, William, 1978. "The Value of an Option to Exchange One Asset for Another," Journal of Finance, American Finance Association, vol. 33(1), pages 177-86, March.
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