Jumps in Commodity Prices: New Approaches for Pricing Plain Vanilla Options

41 Pages Posted: 27 Feb 2021 Last revised: 24 Jun 2022

See all articles by Carme Frau

Carme Frau

Complutense University of Madrid (UCM)

John Crosby

University of Maryland - Robert H. Smith School of Business

Date Written: December 24, 2020

Abstract

We present a new term-structure model for commodity futures prices based on Trolle and Schwartz (2009) which we extend by incorporating multiple jump processes. Our work explores the valuation of plain vanilla options on futures prices when the spot price follows a log-normal process, the forward cost of carry curve and the volatility are stochastic variables, and the spot price and the forward cost of carry allow for time-dampening jumps. We obtain an analytical representation of the characteristic function of the futures prices and, hence, also for plain vanilla option prices using the fast Fourier transform (FFT) methodology. We price options on WTI crude oil futures contracts using our model and extant models. We obtain higher accuracy than earlier models and save significantly in computing time.

Keywords: Commodities, crude oil, futures prices, option pricing, Fourier transform, fast Fourier transform, term-structure model, analytical solution, stochastic volatility, jump-diffusion.

JEL Classification: G13

Suggested Citation

Frau, Carme and Crosby, John, Jumps in Commodity Prices: New Approaches for Pricing Plain Vanilla Options (December 24, 2020). Available at SSRN: https://ssrn.com/abstract=3754835 or http://dx.doi.org/10.2139/ssrn.3754835

Carme Frau (Contact Author)

Complutense University of Madrid (UCM) ( email )

Dpto. Economía Cuantitativa
Facultad Ciencias Económicas
Campus de Somosaguas, Madrid 28223
Spain

John Crosby

University of Maryland - Robert H. Smith School of Business ( email )

College Park, MD 20742-1815
United States
+447979901892 (Phone)

HOME PAGE: http://www.john-crosby.co.uk/

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