Closed form approximations for spread options

Venkatramanan, Aanand and Alexander, Carol (2011) Closed form approximations for spread options. Applied Mathematical Finance, 18 (5). pp. 447-472. ISSN 1350-486X

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Abstract

This article expresses the price of a spread option as the sum of the prices of two compound options. One compound option is to exchange vanilla call options on the two underlying assets and the other is to exchange the corresponding put options. This way we derive a new closed form approximation for the price of a European spread option and a corresponding approximation for each of its price, volatility and correlation hedge ratios. Our approach has many advantages over existing analytical approximations, which have limited validity and an indeterminacy that renders them of little practical use. The compound exchange option approximation for European spread options is then extended to American spread options on assets that pay dividends or incur costs. Simulations quantify the accuracy of our approach; we also present an empirical application to the American crack spread options that are traded on NYMEX. For illustration, we compare our results with those obtained using the approximation attributed to Kirk (1996, Correlation in energy markets. In: V. Kaminski (Ed.), Managing Energy Price Risk, pp. 71–78 (London: Risk Publications)), which is commonly used by traders.

Item Type: Article
Keywords: spread options, exchange options, American options, analytical approximation, Kirk's approximation, correlation skew
Schools and Departments: School of Business, Management and Economics > Business and Management
Subjects: H Social Sciences > HG Finance
Depositing User: Carol Alexander
Date Deposited: 11 Sep 2012 11:10
Last Modified: 23 Jul 2013 15:26
URI: http://sro.sussex.ac.uk/id/eprint/40631
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