Analogy Based Valuation of Commodity Options

26 Pages Posted: 2 Jan 2015 Last revised: 11 Feb 2015

See all articles by Hammad Siddiqi

Hammad Siddiqi

University of the Sunshine Coast-School of Business

Date Written: February 2015

Abstract

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.

Keywords: Implied Volatility Smile, Implied Volatility Skew, Reverse Skew, Forward Skew, Analogy Making, Commodity Call Option, Commodity Futures Contract

JEL Classification: G13, G12

Suggested Citation

Siddiqi, Hammad, Analogy Based Valuation of Commodity Options (February 2015). Available at SSRN: https://ssrn.com/abstract=2544347 or http://dx.doi.org/10.2139/ssrn.2544347

Hammad Siddiqi (Contact Author)

University of the Sunshine Coast-School of Business ( email )

Brisbane, QLD 70010
Australia
+61404900497 (Phone)

HOME PAGE: http://www.usc.edu.au/staff-repository/dr-hammad-siddiqi

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