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Seasonal Stochastic Volatility: Implications for the Pricing of Commodity Options

Author

Listed:
  • Janis Back

    (WHU - Otto Beisheim School of Management)

  • Marcel Prokopczuk

    (ICMA Centre, Henley Business School, University of Reading)

  • Markus Rudolf

    (WHU - Otto Beisheim School of Management)

Abstract

Many commodity markets contain a strong seasonal component in volatility. In this paper, the importance of this seasonal behavior for the pricing of commodity options is analyzed. We propose a stochastic volatility model where the drift term of the variance process captures the observed seasonal pattern in volatility. This framework allows us to derive semi-closed-form pricing formulas for the valuation of options on commodity futures. In the main part of the paper, we empirically study the impact of the proposed seasonal stochastic volatility model on the pricing accuracy of natural gas futures options traded at the New York Mercantile Exchange (NYMEX). Our results demonstrate that allowing stochastic volatility to fluctuate seasonally significantly reduces pricing errors for these contracts.

Suggested Citation

  • Janis Back & Marcel Prokopczuk & Markus Rudolf, 2011. "Seasonal Stochastic Volatility: Implications for the Pricing of Commodity Options," ICMA Centre Discussion Papers in Finance icma-dp2011-16, Henley Business School, University of Reading.
    • Handle: RePEc:rdg:icmadp:icma-dp2011-16
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    More about this item

    Keywords

    Commodities; Seasonality; Stochastic volatility; Options pricing; Natural gas;
    All these keywords.

    JEL classification:

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

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