Analogy Based Valuation of Commodity Options

Typically, three types of implied volatility smiles are seen in commodity options: the reverse skew, the smile, and the forward skew. I put forward an economic explanation for all three types of implied volatility smiles based on the idea that a commodity call option is valued in analogy with its underlying futures contract, where the underlying futures price follows geometric Brownian motion. Closed form solutions for commodity calls and puts exist in the presence of transaction costs. Analogy based jump diffusion model is also developed. The smiles are steeper with jump diffusion when compared with smiles with geometric Brownian motion.


Issue Date:
2015-01
Publication Type:
Working or Discussion Paper
DOI and Other Identifiers:
Record Identifier:
https://ageconsearch.umn.edu/record/197334
PURL Identifier:
http://purl.umn.edu/197334
Total Pages:
26
JEL Codes:
G13
Series Statement:
Finance
WPF15_1




 Record created 2017-04-01, last modified 2020-10-28

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