Analogy Based Valuation of Commodity Options
26 Pages Posted: 2 Jan 2015 Last revised: 11 Feb 2015
Date Written: February 2015
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: Suggested Citation