Pricing and Hedging European Energy Derivatives: A Case Study of WTI Oil Options

Abstract

This study extends the mean‐reversion dynamic framework of (Pilipovic, Energy risk: Valuing and managing energy derivatives, 1997) and (Schwartz, The stochastic behavior of commodity prices: Implications for pricing and hedging, Journal of Finance52, 1997, 923) and focuses on developing a variety of continuous‐time commodity‐pricing and hedging models by analyzing the pricing and hedging errors found in an empirical investigation of options contracts on light sweet crude oil traded on the New York Mercantile Exchange. Thus, this study contributes to furthering the applicability of the models developed. The inclusion of the benchmark Black‐Scholes pricing model generates systematic biases that are consistent with (Bakshi, Cao and Chen, Handbook of Quantitative Finance and Risk Management, 2010). The mean‐reversion jump‐diffusion and seasonality option‐pricing model best describes the extreme price volatility experienced during a financial collapse, but the mean‐reversion and seasonality option‐pricing model offers the best pricing and hedging capability for other periods. The performances of hedging models are generally consistent with pricing errors.

Pricing the (European) option to switch between two energy sources: An application to crude oil and natural gas

“…Analogously, the increased consumption of gasoline in the U.S. during the summer generates a price increase (Source: U.S. Energy Information Administration). Moreover, Auer (2014) exhibits a daily seasonality of crude oil market while Hsu et al (2014) exhibit seasonality in WTI oil options. Analogously, gasoline and heating oil markets exhibit seasonality (Clark, 2014).…”

Path Averaged Option Value Criteria for Selecting Better Options

“…Beginning in 1973, it was described that a mathematical framework for finding the fair price of a European option by Black and Scholes [1,2], several numerical methods have been presented for the cases where analytic solutions are neither available nor easily computable. See more details about numerical methods such as finite difference method (FDM) [3,4,5,6,7,8,9,10,11,12,13], finite element method [14,15,16], finite volume method [17,18,19], and a fast Fourier transform [20,21,22,23,24]. For convenience, we use the closed-form of the Black-Scholes equation in this work.…”