Asian basket options and implied correlations in energy markets

We address the problem of valuation and hedging of Asian basket and spread options derivatives common in energy markets. We extend the Generalized LogNormal approach, introduced in Borovkova et al. (2007), to Asian basket options and apply it to energy option markets. We provide closed form formulae for the option price and the greeks, which is extremely useful for option traders. Inverting the option pricing formula allows us to imply the correlation between the assets in the spread from liquid spread option prices. Numerical simulations and the application to energy markets show that our approach performs remarkably well in terms of option pricing and delta hedging. We analyze the option’s sensitivity to volatilities and correlations, and demonstrate that the implied correlation between NYMEX crude oil and heating oil prices shows the behavior similar to the implied volatility skew.