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From the Samuelson Volatility Effect to a Samuelson Correlation Effect: Evidence from Crude Oil Calendar Spread Options

  • Lorenz Schneider
  • Bertrand Tavin
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    We introduce a multi-factor stochastic volatility model based on the CIR/Heston stochastic volatility process. In order to capture the Samuelson effect displayed by commodity futures contracts, we add expiry-dependent exponential damping factors to their volatility coefficients. The pricing of single underlying European options on futures contracts is straightforward and can incorporate the volatility smile or skew observed in the market. We calculate the joint characteristic function of two futures contracts in the model in analytic form and use the one-dimensional Fourier inversion method of Caldana and Fusai (JBF 2013) to price calendar spread options. The model leads to stochastic correlation between the returns of two futures contracts. We illustrate the distribution of this correlation in an example. We then propose analytical expressions to obtain the copula and copula density directly from the joint characteristic function of a pair of futures. These expressions are convenient to analyze the term-structure of dependence between the two futures produced by the model. In an empirical application we calibrate the proposed model to volatility surfaces of vanilla options on WTI. In this application we provide evidence that the model is able to produce the desired stylized facts in terms of volatility and dependence. In a separate appendix, we give guidance for the implementation of the proposed model and the Fourier inversion results by means of one and two-dimensional FFT methods.

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    File URL: http://arxiv.org/pdf/1401.7913
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    Paper provided by arXiv.org in its series Papers with number 1401.7913.

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    Date of creation: Jan 2014
    Date of revision: Feb 2015
    Handle: RePEc:arx:papers:1401.7913
    Contact details of provider: Web page: http://arxiv.org/

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    1. Heston, Steven L, 1993. "A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options," Review of Financial Studies, Society for Financial Studies, vol. 6(2), pages 327-43.
    2. Darrell Duffie & Jun Pan & Kenneth Singleton, 1999. "Transform Analysis and Asset Pricing for Affine Jump-Diffusions," NBER Working Papers 7105, National Bureau of Economic Research, Inc.
    3. Bakshi, Gurdip & Madan, Dilip, 2000. "Spanning and derivative-security valuation," Journal of Financial Economics, Elsevier, vol. 55(2), pages 205-238, February.
    4. Bjerksund, Petter & Stensland, Gunnar, 2006. "Closed form spread option valuation," Discussion Papers 2006/20, Department of Business and Management Science, Norwegian School of Economics.
    5. Black, Fischer, 1976. "The pricing of commodity contracts," Journal of Financial Economics, Elsevier, vol. 3(1-2), pages 167-179.
    6. Peter Christoffersen & Steven Heston & Kris Jacobs, 2009. "The Shape and Term Structure of the Index Option Smirk: Why Multifactor Stochastic Volatility Models Work so Well," CREATES Research Papers 2009-34, School of Economics and Management, University of Aarhus.
    7. 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.
    8. Aanand Venkatramanan & Carol Alexander, 2011. "Closed Form Approximations for Spread Options," Applied Mathematical Finance, Taylor & Francis Journals, vol. 18(5), pages 447-472, January.
    9. Anders B. Trolle & Eduardo S. Schwartz, 2009. "Unspanned Stochastic Volatility and the Pricing of Commodity Derivatives," Review of Financial Studies, Society for Financial Studies, vol. 22(11), pages 4423-4461, November.
    10. Stein, Elias M & Stein, Jeremy C, 1991. "Stock Price Distributions with Stochastic Volatility: An Analytic Approach," Review of Financial Studies, Society for Financial Studies, vol. 4(4), pages 727-52.
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