Pricing and risk management of spread options on Brent and West Texas Intermediate oil futures markets

Abstract

This thesis investigates the price spread between futures on Brent oil from the Intercontinental Exchange and West Texas Intermediate oil from the New York Mercantile Exchange. Historical futures data is calibrated to a multi-factor forward curve model based on Clewlow and Strickland (2000), and the model is fitted, based on Sollie (2013)'s approach, to al- low for non-constant volatility. An asymmetric generalized autoregressive heteroskedastic model based on Nelson (1991), and principal component analysis is performed to find key common factors explaining the forward curve dynamics. The model is used to draw realisations of the forward curves for Brent and West Texas Intermediate (WTI) crude oils, and three selected realisations are further analysed. Sensitivity analysis is performed on the expected prices at Day 1, and options are priced on the Brent/WTI futures spread with Monte Carlo Simulations. Each realisa- tion is risk managed with delta hedging, attempting to offset movements in the option prices during their lifetime. The delta hedge is rebalanced one time per day for each contract, which this analysis will find is not suffi cient in all cases to capture the extreme volatility in the movement of the underlying assets.