Cutting edge: Incorporating forex volatility into commodity spread option pricing

In this article, Joseph Yechong Chen extends Kirk’s formula to spread option pricing when forex is a stochastic factor and is multiplied to one leg in the payoff formula. The article illustrates the importance of forex risk factors and the need to include them in the business strategies of asset acquisitions and divestitures

Several different forms of spread options are used in energy markets. The most popular ones are European call options on the spread of energy price pairs. If we consider energy prices in different locations and times as individual commodities, a spread option can be generally considered as the right to exchange one unit of a commodity for a certain amount of units of another commodity at given strike price. Examples of spread options are:

(1) Locational spread options: gas transportations