Two and Three factor models for Spread Options Pricing
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1 Two and Three factor models for Spread Options Pricing COMMIDITIES 2007, Birkbeck College, University of London January 17-19, 2007 Sebastian Jaimungal, Associate Director, Mathematical Finance Program, University of Toronto web: and Samuel Hikspoors Ph.D. Candidate, Department of Statistics, University of Toronto
2 Outline Spot Price Dynamics Forward Prices Spreads on Forwards Model Calibration Conclusions Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
3 Spot Price Dynamics Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
4 Spot Price Dynamics Energy and energy commodities markets are unique Well known peculiarities with energy commodities: Markets are illiquid Storage costs (or impossibility of storage) translate into peculiar price behavior Structural issues lead to high volatility levels Prices exhibit strong mean-reversion tendencies Electricity in particular contains fast mean-reverting jumps Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
5 Spot Price Dynamics Geometric Brownian motion fails to capture price fluctuations Mean-reversion is an essential feature One-factor models : Fail to capture the term structure of forward rates Fail to treat the long-run mean reversion as dynamic Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
6 Spot Price Dynamics Pilipovic (1997) first proposed the two-factor meanreverting model Long-run mean θ blows up No-invariant distribution in long-run Does not lead to closed form option prices Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
7 Spot Price Dynamics A stationary two-factor mean-reverting model : Seasonality is modeled through g t X t mean-reverts to Y t Y t mean-reverts to φ Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
8 Spot Price Dynamics Since both X and Y are Gaussian Ornstein-Uhlenbeck processes one finds Here, G s,t and M s,t are deterministic functions of the model parameters and time Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
9 Stochastic Volatility Spot Models A three-factor model: stochastic long-run mean and stochastic volatility Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
10 Stochastic Volatility Spot Models Realized volatility : NYMEX light sweet crude oil 100% 80% 60% 40% 20% 0% Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
11 Stochastic Volatility Spot Models Simulated volatility Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
12 Electricity Spot Price Modeling For Electricity, typical modeling assumptions assume Q t is a Compound Poisson process (or possibly Lévy) When calibrated to real data one finds: Mean-reversion is very high to draw down jumps This pushes diffusive volatility artificially high Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
13 Electricity Spot Price Modeling We propose a natural extension of the two-factor and three-factor diffusion model: Jump and diffusion reversion rates are decoupled No artificially high diffusive volatilities Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
14 Forward Prices Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
15 Forward Prices The forward price for two-factor model is affine : For the three-factor model, we carry out a singular perturbation expansion by assuming : Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
16 Forward Prices The T-maturity forward price satisfies: Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
17 Forward Prices We solve this PDE, and prove the error bound, to order ε 1/2 using singular perturbation techniques [á la P. Cotton, J-P Fouque, G. Papanicolaou & R. Sircar (2004) in the context of interest rates] Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
18 Electricity Forward Prices The two-factor jump-diffusion model is also affine: The infinitesimal generator A of the joint processes acts on the forward price process rendering it zero Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
19 Electricity Spot Price Modeling The pricing PDE then reduces to a system of coupled Riccati ODEs Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
20 Spread Options Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
21 Exchange Option Pricing The spread on two forward rates is a very popular product (different assets ): Exact solution difficult (impossible? at least so far!) for K 0 - Put K = 0 Margrabe option Risk-neutral Pricing implies : Use an asset as a numeraire to reduce the stochastic dimensionality? Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
22 Exchange Option Pricing Introduce the measure-q * induced by the following Radon-Nikodym derivative process: The ratio of two forward prices is a Q * -martingale! Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
23 Exchange Option Pricing In particular, for the two-factor model we show Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
24 Exchange Option Pricing For the three-factor model we show, using singular perturbation techniques once again that Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
25 Electricity Exchange Option Valuation The ratio of forward prices F T; T1, T2 is still a martingale under this new Q * -measure However, it is no longer Gaussian Use Fourier transform methods to price Introduce the m.g.f. process of Z T = ln F T; T1, T2 This too is a martingale under the new measure Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
26 Crack Spread Valuation Rewrite the price as follows: Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
27 Crack Spread Valuation Rewrite the price as follows: Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
28 Spot Price Dynamics - Calibration Results Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
29 Calibration The data consists of spot prices and forward curves on corresponding days for crude oil $100 $80 $60 $40 $20 Forward Price $0 08/17/03 03/04/04 09/20/04 04/08/05 10/25/05 05/13/ Term 2-Aug-04 9-Nov Feb May-05 6-Sep Dec-05 Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
30 Calibration We calibrate the model to both data sets simultaneously Computing the sum of squared errors of the forward curve given the spot prices Minimizing first w.r.t. to the hidden process Y Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
31 Calibration Use this estimate in the sum of squared errors for each day separately Minimize over the remaining parameters This procedure yields the daily estimates for the hidden process Y and the risk-neutral model parameters The time-series of X and Y are used to estimate the real-world parameters via regression Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
32 Calibration The calibrated risk-neutral model parameters are β α φ σ X σ Y ρ % 63% The calibrated real-world model parameters are β α φ σ X σ Y ρ % 63% Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
33 Calibration $70 $65 Forward Prices $60 $55 $50 $45 $ Term (years) Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
34 Calibration 1.8% 1.6% 1.4% Relative RMSE 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% 08/17/03 03/04/04 09/20/04 04/08/05 10/25/05 05/13/06 Date Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
35 Calibration We also check the stability of the model parameters through time # Fwd- Curves β α φ σ X σ Y ρ % 19% % 54% % 56% % 60% % 58% % 52% % 58% % 63% Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
36 Concluding Remarks We introduced a two-factor model containing meanreversion to a long run mean-reverting level With and without jumps We introduced a third fast mean-reverting stochastic volatility into the model Obtained forward prices & spreads on forwards in closed form Future work More thorough model calibration including calibrating to electricity data using particle filter approaches Adding a slow mean-reverting stochastic volatility Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
37 Concluding Remarks Thank You! Energy Spot Price Models and Spread Option Pricing S. Jaimungal and S. Hikspoors,
(FRED ESPEN BENTH, JAN KALLSEN, AND THILO MEYER-BRANDIS) UFITIMANA Jacqueline. Lappeenranta University Of Technology.
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