Title: Pricing of Spread Options on Stochastically Correlated Underlyings. Pricing of Spread Options on Stochastically Correlated Underlyings

This report proposes a method to price spread options on stochastically correlated underlying assets. Therefore it provides a more realistic approach towards correlation structure. We generalize a constant correlation tree model developed by Hull (2002) and extend it by the notion of stochastic correlation. The resulting tree model is recombining and easy to implement. Moreover, the numerical convergence of our model is very fast. Our sensitivity analysis with respect to the stochastic correlation parameters shows that the constant correlation model systematically overprices spread options on two stochastically correlated underlying assets. Furthermore, we use our model to derive hedging parameters for the correlation of a spread option and show that the constant correlation model also overprices the hedging parameters.