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Closed-Form Approximations for Spread Option Prices and Greeks
Minqiang Li Georgia Institute of Technology - College of Management Shijie Deng Georgia Institute of Technology - School of Industrial and Systems Engineering Jieyun Zhou Georgia Institute of Technology November 2006 Abstract: We develop a new closed-form approximation method for pricing spread options. Numerical analysis shows that our method is more accurate than existing analytical approximations. Our method is also extremely fast, with computing time more than two orders of magnitude shorter than one-dimensional numerical integration. We also develop closed-form proximations for the greeks of spread options. In addition, we analyze the price sensitivities of spread options and provide lower and upper bounds for digital spread options. Our method enables the accurate pricing of a bulk volume of spread options with different specifications in real time, which offers traders a potential edge in financial markets. The closed-form approximations of greeks serve as valuable tools in financial applications such as dynamic hedging and Value-at-Risk calculations. The availability of a closed-form formula for spread options also helps us understand and design real and financial contracts with embedded spread-option-like features.
Keywords: Spread option, Closed-form approximation, Greeks JEL Classifications: G12, G13, C63 Working Paper SeriesDate posted: December 20, 2006 ; Last revised: February 12, 2008Suggested CitationContact Information
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