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Andrea Roncoroni

ESSEC Business School, Paris - Singapore

Practical Quantitative Analysis in Commodities

June 17-18, 2010

London, UK

Andrea Roncoroni Commodity Asian-Sytle Options

Commodity Price Modelling

Model construction focuses on:

1

Primitives = Input state variables

should be quantities with:

Reliable observations;

Economic signicance.

2

Structural elements = Form of drift, volatility, jump, if any

should be identied using statistical analysis of historical data and

then tted to observed prices.

3

Driving noise terms = Number (&nature) of noise terms

should be assessed based on historical price analysis (e g , exam

of the trajectorial properties of price paths, Principal Components

Analysis, jump ltering).

Andrea Roncoroni Commodity Asian-Sytle Options

Modelling Frameworks

Frameworks: We identify four classes of arbitrage free models for

commodity prices according to selection of primitives:

1

[SC] Spot Price-Convenience Yield Models (Gibson-Schwartz (1990))

primitives = spot price + instantaneous spot convenience yield;

2

[FD] Forward Curve Models (Reisman (1991), Jamshidian (1991))

primitive = forward price curve;

3

[FC] Forward Convenience Yield Models (Cortazar-Schwartz (1994))

primitives = spot price + instantaneous fwd convenience yield;

4

[SP] Spot Price Models (Black (1976))

primitive = spot price (deterministic convenience yield)

Roncoroni, A., Commodity Price Models, in: Cont et al., Encyclopedia of

Quantitative Finance, Wiley (forthcoming).

Andrea Roncoroni Commodity Asian-Sytle Options

Stylized Facts and Market Price Information

Principle Commodity derivatives should be priced using models

reproducing:

1

Stylized facts about underlying price dynamics:

Mean reversion characterizing spot price dynamics,

Time and stochastic patterns aecting historical price volatility,

Jump-like price behavior and non normal returns.

2

Market price information available at the valuation time:

Market quoted forward and futures prices,

Volatility surfaces (liquid option quotes).

Andrea Roncoroni Commodity Asian-Sytle Options

Stylized Facts I: Empirical Evidence

2 4 6 8 10 12

0.16

0.18

0.2

0.22

0.24

0.26

Month

S

t

d

.

D

e

v

.

Corn Historical Volatility, 1980-2009

2 4 6 8 10 12

0.18

0.2

0.22

0.24

0.26

Month

S

t

d

.

D

e

v

.

Soybean Historical Volatility, 1980-2009

2 4 6 8 10 12

0.2

0.21

0.22

0.23

0.24

Month

S

t

d

.

D

e

v

.

Wheat Historical Volatility, 1980-2009

2 4 6 8 10 12

0.4

0.5

0.6

0.7

Month

S

t

d

.

D

e

v

.

HH Gas Historical Volatility, 1990-2007

Andrea Roncoroni Commodity Asian-Sytle Options

Stylized Facts II: Empirical Evidence

Andrea Roncoroni Commodity Asian-Sytle Options

Market Price Information I: Empirical Evidence

0 0.5 1

62

64

66

68

Light,Sweet CrudeOil (Nymex 1-3-2007)

Maturity (years)

0 0.5 1

7

8

9

10

HH Natural Gas (Nymex 1-3-2007)

Maturity (years)

0 0.5 1

1.7

1.8

1.9

2

Heating Oil (Nymex 1-3-2007)

Maturity (years)

0 1 2 3 4

3200

3400

3600

3800

4000

Corn (CBOT 1-12-2006)

Maturity (years)

Andrea Roncoroni Commodity Asian-Sytle Options

Market Price Information II: Empirical Evidence

0.2

0.4

0.6

0.8

1

1.2

0.8

1

1.2

0.35

0.4

0.45

0.5

0.55

0.6

0.65

Moneyness

Smile curve implied by Crude Oil Futures Options on July 7, 2009

Maturity

I

m

p

l

i

e

d

V

o

l

Andrea Roncoroni Commodity Asian-Sytle Options

Commodity Asian-Style Options

Discrete monitoring = Prices are monitored every time units.

Underlying variable = Price average

n

i =0

i

S

i

.

Name Weight

j

Average Avg

n

Standard arithmetic 1/ (n + 1) (n + 1)

1

n

i =0

S

i

Volume weighed V

j

/

i

V

i

(

k

V

k

)

1

n

i =0

V

i

S

i

Cash ows:

Fixed strike Floating strike

max Avg

n

K, 0 max Avg

n

S

n

, 0

Andrea Roncoroni Commodity Asian-Sytle Options

Articles

Analytical Pricing of Commodity Asian-Style Options under Discrete

Monitoring (with G.Fusai,M.Marena). JBF32(10), 2033-2045, 2008

Analytical pricing (up to FT) of arithmetic average options on:

dS

t

=

t

S

t

dt +

t

_

S

t

dW

t

+ dJ

t

(VC-SQRT-J)

(Variants: CC-SQRT:const.coe.+dJ=0, CV-SQRT:const.vol.+dJ=0; SC-SQRT:seas.coe.+dJ=0, C-SQRT-J:const.par.)

Control Variates for Asian-Style Options under Seasonality, Stochastic

Volatility and Jumps (with G.Fusai, M.Marena). WP, ESSEC, 2009

Analytical pricing (up to FT) of geometric average options on:

d lg S

t

= (

t

m

t

v

t

/2) dt +

_

v

t

dW

1

t

+ dJ

1

t

(SV-JJ)

dv

t

= (

t

v

t

) dt +

_

v

t

dW

2

t

+ dJ

2

t

.

and use as control variable for pricing arithmetic average options. (Variants: JD:v=const., SV=dJ1=dJ2=0, SV-J:dJ2=0)

Andrea Roncoroni Commodity Asian-Sytle Options

Transform-Based Option Pricing (Carr-Madan (1999))

Pay-o (including call and xed-strike Asian):

max 0, Y

T

k , k = constant, Y _ 0.

1

Vanilla call Y

T

= S

n

, = 1, k = K;

2

Fixed-strike Asian Y

T

=

S

i

, = 1/ (n + 1), k = (n + 1) K.

Laplace transform of the option price wrt strike k:

/:

call price=funct.of strike k

..

C

0,Y

0

(T, k)

Laplace transf.=funct.of

..

/[C] () ,

_

+

0

e

k

C

0,Y

0

(T, k) dk .

Andrea Roncoroni Commodity Asian-Sytle Options

Transform-Based Option Pricing (Carr-Madan (1999))

Laplace transform:

/[C] ()

AF price

= e

rT

_

_

_

_

E

0

_

e

Y

T

_

2

+

E

0

[Y

T

]

2

_

_

_

_

.

Laplace inversion Option price:

C

0,Y

0

(T, k) = e

rT

_

/

1

_

/[Y

T

] ()

()

2

_

(k) +E

0

[Y

T

] k

_

.

Andrea Roncoroni Commodity Asian-Sytle Options

Arithmetic Average Options under a CV-SQRT Model

Constant volatility square-root dynamics:

dS

u

= (r

u

c

u

) S

u

du +

_

S

u

dW

u

, starting at: S

0

= x.

Curve tting: Set r

t

c

t

=

t

;

Input Fwd prices observed for maturities up to option expiration.

Problem Find

t

such that the spot model ts fwd prices.

Solution F

0,T

= E

0

(S

T

) = x exp

_

T

0

s

ds i:

T

=

T

ln F

0,T

.

Andrea Roncoroni Commodity Asian-Sytle Options

Main Result (Fusai-Marena-Roncoroni (2008))

Theorem: Mgf S

t

Mgf (nal price, arithm.avg.price):

v

0,x

(n, ; , ) , E

0

_

e

[

S

n

+

j

S

j

]

_

= e

0

(;,)x

,

where

j

(; , ) satises the recursive equation:

j

(; , ) = A

_

;

j +1

(; , )

_

+

j

, for j = n 1 0,

n

(, , ) = +

n

(starting condition),

with A(; ) = e

(r c)

/

_

1 +

2

_

e

(r c)

1

_

/2 (r c)

_

.

Andrea Roncoroni Commodity Asian-Sytle Options

Pricing Formula

Price Fixed-strike Arithmetic Asian-style option price:

V = e

rt

_

1

2

_

1

_

a

l

+

_

1

a

l

_

1

e

n+1

K(n+1)

v

0,x

(n, ; 0, )

2

d

+

e

(r c)(n+1)

1

(e

r

1) (n + 1)

x K (n + 1)

_

.

Extensions:

1

Mean reversion + Time-varying volatility;

2

Time-varying drift + Jumps.

Andrea Roncoroni Commodity Asian-Sytle Options

Geometric Average Options under a CC-SV-JJ Model

Constant coe. stoch.vol. double jump model:

d lg S

t

= (r c m

t

v

t

/2) dt +

_

v

t

dW

1

t

+ dJ

1

t

(SV-JJ)

dv

t

= ( v

t

) dt +

_

v

t

dW

2

t

+ dJ

2

t

dt = Cov

_

dW

(1)

, dW

(2)

_

,

1

=

2

, J

i

i .i .d.

~ A

Pay-o (Geometric Asian-style call):

C

g

(T, K) = max

_

_

0,

_

n

k=0

S

k

_ 1

n+1

geometric avg.=:Y

T

K

_

_

.

Andrea Roncoroni Commodity Asian-Sytle Options

Main Result (Fusai-Marena-Roncoroni (2009))

Theorem: Cf (lg S

t

, v

t

) Cf log(geom.avg.price Y

T

):

0,x,v

(n, ; u) = E

0

_

e

iuY

T

_

= e

iux+

1

(u;n,)v+

1

(u;n,)

,

where

j

and

j

satisfy the recursive equations (j : n 1 1):

j

(u; n, ) = D

_

(n j + 1) / (n + 1) , i

j +1

(u; n, ) ;

_

,

starting at:

n

(u; n, ) = D (u/ (n + 1) , 0; ) ;

j

(u; n, ) =

j +1

(u; n, )

+C

_

(n j + 1) / (n + 1) u, i

j +1

(u; n, ) ;

_

+J

_

(n j + 1) / (n + 1) u, i

j +1

(u; n, ) ;

_

,

starting at:

n

(u; n, ) = C (u/ (n + 1) , 0; ) + J (u/ (n + 1) , 0; ),

and D, C, J are given in analytic form.

Andrea Roncoroni Commodity Asian-Sytle Options

Test 1: Discrete vs. Continuous Monitoring Rules

Model = Square-root with constant volatility Analytical formula

of joint mgf

_

S (T) , T

1

_

T

0

S (u) du

_

.

n=12 n=50 n=250 cts

k Price %Di Price %Di Price %Di Price

-0.05 0.16897 -1.58 0.17099 -0.40 0.17153 -0.08 0.17167

0 0.14102 -1.91 0.14306 -0.48 0.14362 -0.10 0.14376

0.05 0.11540 -2.33 0.11745 -0.59 0.11800 -0.12 0.11814

1

Price dierences | as the number of monitoring dates .

2

The speed of convergence is almost linear in n (slow).

(Conv.speed for barrier options is even slower, - 1/

_

n.)

Andrea Roncoroni Commodity Asian-Sytle Options

Test 2: Comparison to Methods for the Market Model

Methods for geometric Brownian motion dynamics

- Geman and Yor (1993): Laplace trans.inv. with cont.monitoring

- Turnbull and Wakeman (1991) approximation of the lognormal price distribution

Comparative model

SQRT

:Call

SRmod.

(

SQRT

) = Call

BSmod.

(

GBM

)

K

GBM

Option Prices in the GBM case

SR

Option price (SQRT)

Inv.Lap. Logn,

90 0.1 15.39763 15.39906 0.97411 15.39890

110 0.1 1.41362 1.41080 1.02356 1.41070

90 0.5 19.30572 19.55391 4.86178 19.37724

110 0.5 10.07128 10.18997 5.11247 10.06599

1

SQRT accurately approx.GBM quotes, yet SQRT real time val.

2

SQRT lies between the two approx.quotes (but for deep OTM)

Andrea Roncoroni Commodity Asian-Sytle Options

Test 3: Including a Quoted Forward Curve

Methods Compute prices with at and market fwd curves

n=5

K Flat Non Flat %Di

-0.05 0.14 0.15 4.04

0 0.13 0.13 3.99

0.05 0.12 0.12 3.95

n=250

K Flat Non Flat %Di

-0.05 0.15 0.17 9.73

0 0.14 0.15 9.78

0.05 0.13 0.14 9.82

1

Monitoring frequency ; price discrepancy between considering

and discarding the quoted forward curve |

2

This is important in commodity/energy markets where fwd curves

often display seasonality

Andrea Roncoroni Commodity Asian-Sytle Options

Test 4: Including Seasonal Volatility

Step I Compute historical avg.vol.

GBM

for each month

Step II Conv.

GBM

SR

:

GBM

Spot=

SR

_

Spot

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

GBM

0.17 0.14 0.16 0.17 0.20 0.22 0.27 0.22 0.19 0.18 0.16 0.13

SR

10.2 8.59 9.74 10.2 12.4 13.8 16.3 13.7 11.4 11.2 9.80 8.40

Step III Building 3 vols

Flat average vol.

(a)

:

2

(a)

_

T

0

1

F

0,s

ds =

_

T

0

2

s

F

0,s

ds

Flat implied vol.

(b)

matching a benchmark option (ATM Asian

with a 5-period monitoring)

Time varying historical market volatility structure

Andrea Roncoroni Commodity Asian-Sytle Options

Test 4: Including Seasonal Volatility

Results

K/S(t) n

a

=11.21

%Di

V(

a

)-V(nf)

b

=10.84

%Di

V(

b

)-V(nf)

Non Flat Vol.

0.9 12 460.72 0.59 458.62 0.13 458.03

1 12 196.08 3.02 191.37 0.54 190.34

1.1 12 54.71 9.03 50.80 1.23 50.18

0.9 1000 472.95 0.66 470.81 0.20 469.85

1 1000 206.46 3.35 201.67 0.96 199.76

1.1 1000 60.28 10.08 56.16 2.55 54.76

1

Important price dierences

2

This eect is rather signicant for OTM options

3

Method 2) ~ method 1), but requires option price observation

Andrea Roncoroni Commodity Asian-Sytle Options

Test 5: Variance Reduction

Description: Evaluate an arithmetic average option using:

Naive Monte Carlo,

Geometric control variate,

Normal antithetic variables.

Control variate:

CV

=

arith avg

g (X) +

estim.by simulation

Cov (g (X) , f (X))

Var (f (X))

_

_

_

geo avg

f (X)

geo opt.priceanalytic

..

E(f (X))

_

_

_

.

Antithetic:

AV

:=

1

n

n

i =1

g

_

X

_

A

1

i

, A

2

i

__

+ g

_

X

_

A

1

i

, A

2

i

__

2

.

Andrea Roncoroni Commodity Asian-Sytle Options

Test 5: Variance Reduction

Results: SV model Prices and standard errors:

|option+method / monitoring 12 25 50 100 250

Geo Analytic (our method)

Price (x0.01)

5.05161 5.06461 5.07075 5.07386 5.07574

Geo Naive Monte Carlo

Price (x0.01) + Std Error (x0.00001)

4.97484

(5.55)

5.02985

(5.58)

5.05107

(5.61)

5.06507

(5.62)

5.07065

(5.64)

Arithmetic Naive Monte Carlo 5.10154

(5.60)

5.15143

(5.66)

5.16970

(5.69)

5.18261

(5.71)

5.18737

(5.72)

Arithmetic Control Variate 5.17961

(0.12)

5.18672

(0.12)

5.18966

(0.12)

5.19152

(0.12)

5.19253

(0.12)

Arithmetic Antithetic Variable 5.10398

(1.96)

5.14992

(1.99)

5.17290

(2.00)

5.18120

(2.01)

5.18971

(2.01)

Arithmetic Antithetic+Control 5.17913

(0.10)

5.18641

(0.10)

5.18959

(0.10)

5.19140

(0.10)

5.19255

(0.10)

1

Control variate dramatically reduces standard errors, while

preserving the computational time (analytical method is almost in

real-time);

2

Antithetic variates reduces standard errors from both naive MC and

control variate, whereas computational time almost doubles.

Andrea Roncoroni Commodity Asian-Sytle Options

Test 5: Variance Reduction

Results: SV Model Convergence and std.errors:

|ratio or method/ n.simul. 100,000 200,000 300,000 400,000 500,000

MC/Antithetic Variable 2.84707 2.84326 2.84170 2.84381 2.84391

MC/Control Variate 46.39385 46.08531 45.77696 45.77019 45.88352

MC/Antithetic+Control V 59.69837 59.20087 58.81804 58.83800 58.94951

Arithmetic Naive Monte Carlo

(x 0.01)

5.16737 5.17290 5.18414 5.18125 5.18159

Arithmetic Control Variate 5.19153 5.19143 5.19156 5.19147 5.19137

Arithmetic Antithetic Variable 5.17596 5.17491 5.17556 5.17965 5.18035

Arithmetic Antithetic+Control 5.19130 5.19129 5.19138 5.19130 5.19126

1

Variance reduction is dramatic with control variate;

2

Control variate leads to fast convergence.

Andrea Roncoroni Commodity Asian-Sytle Options

Conclusion

We price arithmetic Asian-style options under realistic

assumptions:

1

Averages are discretely monitored Real-world practice

2

SQRT Model Analytic pricing formulae

3

SV-JJ Model Eective control variate

4

The underlying dynamics exhibit stylized behavioral features:

Time varying volatility Seasonal price vol.

Jumps Spikes and non-normal returns

5

Market information is accounted for using:

Time varying drift Fitting the quoted fwd curve/price trend

Stochastic volatility + jumps smile tting (to be conducted)

Andrea Roncoroni Commodity Asian-Sytle Options

The Author

Andrea Roncoroni is Professor of Finance at ESSEC Business School (Paris - Singapore) and regular Lecturer at Bocconi University

(Milan), He holds a BS in Economics from Bocconi University (Italy), an MS in Mathematics from the Courant Institute of Mathematical

Sciences (New York) and PhD's in Applied Mathematics and Finance from the University of Trieste (Italy) and University Paris Dauphine

(France), respectively. His research interests cover Energy Finance, Financial Econometrics and Derivative Structuring. He has consulted

for private companies (e.g., Gaz de France, Edison Trading, EGL, Dong Energy) and lectured for public institutions (e.g., International

Energy Agency, Central Bank of France, Italian Stock Exchange). He regularly writes on academic journals and has recently published

"Implementing Models in Quantitative Finance: Methods and Cases" (with G.Fusai), edited by Springer-Verlag in 2008.

E-mail: andrea.roncoroni@gmail.com

Web page: http://www45.essec.edu/faculty/andrea-roncoroni

Andrea Roncoroni Commodity Asian-Sytle Options

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