Correlation Surface for Spread Option
I’ve been looking for a good way to model correlation skew on a spread option. Imagine I have the ATM
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By spread options, I assume you mean CMS Curve options
While these products do trade in the broker market, they are not the most liquid products and finding historical volatility/correlation may not be the easiest task
What are you talking about WRT spread option? Are you talking about derivatives? calendar call-spreads and put-spreads, cash-less collars, etc.?
What is a correlation surface or skew? How does it correspond to leveraging investment dollars? What does one leg of your contracts being ATM have to do with a correlation surface?
I am talking about a commodity spread option. Power heat rate calls or oil crack spreads... In a commodity spread option in lieu of skewing vol of the underlying as you move away from ATM you use skew the term structure of correlation. What I don't know is if it's a few corrs or if its something more like an exponential function
http://help.cqg.com/cqgic/default.htm#!Documents/kirksapproximation.htm
There is a simple method based on the Gaussian copula but it does not take into account a correlation skew. A back of the envelope method is to use a call and a put of appropriate money ness and then use an analytical approximation with some correlation. That’s for pricing. Actually figuring out the correlation skew is not straight forward, you can check historical réalisation vs the spread but that will be very noisy.
Yeah the regression makes sense. Where I get nervous is that regression isn’t “market”. What I’ll probably do is try to mimic the shape of the NYMEX Vol surface and compare that to th results of the regression. If it appears market in gas options is way more expensive (for vol skew) then I’ve done it wrong.
I don’t know much about energy so it’s hard for me to judge, obviously (I’d love to pick your brain about it at some point). If correlation tends to pick up in a panic (think equities, for example) you should see correlation skew consistent with the underlying skews while if it’s something that should decorrelate in a panic, you should see that on a Lowess regression (but then you gonna have trouble getting a stable model)
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