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Department of Business and Management Science, Norwegian School of Economics (NHH) Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)

No 2006/20:
Closed form spread option valuation

Petter Bjerksund () and Gunnar Stensland ()

Abstract: This paper considers the valuation of a spread call when asset prices are lognormal. The implicit strategy of the Kirk formula is to exercise if the price of the long asset exceeds a given power function of the price of the short asset. We derive a formula for the spread call value, conditional on following this feasible but non-optimal exercise strategy. Numerical investigations indicate that the lower bound produced by our formula is extremely accurate. The precision is much higher than the Kirk formula. Moreover, optimizing with respect to the strategy parameters (which corresponds to the Carmona-Durrleman procedure) yields only a marginal improvement of accuracy (if any).

Keywords: Spread option; closed form; valuation formula; lognormal asset prices; (follow links to similar papers)

JEL-Codes: C63; D81; G12; G13; (follow links to similar papers)

18 pages, December 1, 2006

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