Analytic Approximations for Spread Options

Carol Alexander and Aanand Venkatramanan ()
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Aanand Venkatramanan: ICMA Centre, University of Reading

ICMA Centre Discussion Papers in Finance from Henley Business School, University of Reading

Abstract: Even in the simple case that two price processes follow correlated geometric Brownian motions with constant volatility no analytic formula for the price of a standard European spread option has been derived, except when the strike is zero in which case the option becomes an exchange option. This paper expresses the price of a spread option as the price of a compound exchange option and hence derives a new analytic approximation for its price and hedge ratios. This approximation has several advantages over existing analytic approximations, which have limited validity and an indeterminacy that renders them of little practical use. Simulations quantify the accuracy of our approach and demonstrate the indeterminacy and inaccuracy of other analytic approximations. The American spread option price is identical to the European option price when the two price processes have identical drifts, and otherwise we derive an expression for the early exercise premium. A practical illustration of the model calibration uses market data on American crack spread options.

Keywords: Asset pricing; Spread options; Exchange options; American Options (search for similar items in EconPapers)
JEL-codes: C02 C29 G12 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2007-08
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Citations: View citations in EconPapers (1)

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Related works:
Working Paper: Analytic Approximations for Spread Options (2009)
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