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Analytic Approximations for Spread Options

  • Carol Alexander


    (ICMA Centre, University of Reading)

  • Aanand Venkatramanan


    (ICMA Centre, University of Reading)

Even 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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Paper provided by Henley Business School, Reading University in its series ICMA Centre Discussion Papers in Finance with number icma-dp2007-11.

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Length: 25 pages
Date of creation: Aug 2007
Date of revision:
Handle: RePEc:rdg:icmadp:icma-dp2007-11
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  1. Li, Minqiang, 2008. "Closed-Form Approximations for Spread Option Prices and Greeks," MPRA Paper 6994, University Library of Munich, Germany.
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