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Crack spread option pricing with copulas
Authors:Hemantha S B Herath  Pranesh Kumar  Amin H Amershi
Institution:1. Department of Accounting, Faculty of Business, Brock University, Taro Hall 240, 500 Glenridge Avenue, St. Catharines, ON, Canada, L2S 3A1
2. Department of Mathematics, University of Northern British Columbia, 3333 University Way, Prince George, BC, Canada, V2N 4Z9
3. DeGroote School of Business, McMaster University, 120 Main Street, Hamilton, ON, Canada, L8S 4M4
Abstract:A copula-based approach for pricing crack spread options is described. Crack spread options are currently priced assuming joint normal distributions of returns and linear dependence. Statistical evidence indicates that these assumptions are at odds with the empirical data. Furthermore, the unique features of energy commodities, such as mean reversion and seasonality, are ignored in standard models. We develop two copula-based crack spread option models using a simulation approach that address these gaps. Our results indicate that the Gumbel copula and standard models (binomial, and Kirk and Aron (1995)) mis-price a crack spread option and that the Clayton model is more appropriate. We contribute to the energy derivatives literature by illustrating the application of copula models to the pricing of a heating oil–crude oil “crack” spread option.
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