Long term spread option valuation and hedging
نویسندگان
چکیده
This paper investigates the valuation and hedging of spread options on two commodity prices which in the long run are cointegrated. For long term option pricing the spread between the two prices should therefore be modelled directly. This approach offers significant advantages relative to the traditional multi-factor spread option pricing model since the correlation between two asset returns is notoriously hard to model. In this paper, we propose one and two factor models for spot spread processes under both the risk-neutral and market measures. We develop pricing and hedging formulae for options on spot and futures spreads. Two examples of spread options 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. JEL classification: G12
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