Subordinated Levy Processes and Applications to Crude Oil Options

26 Pages Posted: 3 Mar 2006

See all articles by Noureddine Krichene

Noureddine Krichene

International Monetary Fund (IMF) - African Department

Date Written: September 2005

Abstract

One approach to oil markets is to treat oil as an asset, besides its role as a commodity. Speculative and nonspeculative activity by investors in the derivatives markets could be responsible for a sizable increase in oil prices. This paper recognizes both the consumption and investment aspects of crude oil and proposes Levy processes for modeling uncertainty and options pricing. Calibration to crude oil futures` options shows high volatility of oil futures prices, fat-tailed, and right-skewed market expectations,implying a higher probability mass on crude oil prices remaining above the futures` level. These findings support the view that demand for futures contracts by investors could lead to excessively high price volatility.

Keywords: Characteristic functions, Esscher transform, Fourier transform, Inverse problem, Levy processes, Option pricing, Risk-neutral density, Volatility

JEL Classification: C63, G13, Q49

Suggested Citation

Krichene, Noureddine, Subordinated Levy Processes and Applications to Crude Oil Options (September 2005). IMF Working Paper No. 05/174, Available at SSRN: https://ssrn.com/abstract=888043

Noureddine Krichene (Contact Author)

International Monetary Fund (IMF) - African Department ( email )

1700 19th Street, NW
Washington, DC 20431
United States

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