Pricing options on illiquid assets using liquid market benchmarks: an application to energy markets

Battle Count: 74

Highly relevant for energy trading desks and quantitative researchers working on commodity derivatives. The framework directly addresses a practical problem: pricing and hedging options on illiquid refined products using liquid crude oil benchmarks. The crack-spread-based volatility correction is economically motivated and practically implementable. However, the Monte Carlo requirement limits real-time applicability, and the proprietary data requirement restricts accessibility. Most relevant for mid-to-long-term risk management and relative value strategies rather than high-frequency trading.

High complexity due to multiple interacting components: (1) calibration of a Gaussian mixture local volatility model to Brent option quotes, (2) construction of rolling futures series with roll-gap adjustments, (3) k-medians clustering in 2M-dimensional feature space, (4) interpolation of centroids to build the correction function h, (5) Monte Carlo simulation of correlated local volatility SDEs, (6) inversion of Bachelier pricing formula to obtain implied volatilities. Requires expertise in stochastic calculus, numerical methods, and energy market microstructure.

The paper provides detailed mathematical formulations, calibration procedures, and parameter choices (N components, k=6 clusters, window lengths). However, no code repository is provided, ICE market data is proprietary, and some implementation details (exact interpolation schemes, Monte Carlo parameters) are not fully specified. The methodology is described thoroughly enough for an expert to reimplement, but exact numerical reproduction would require access to the same ICE settlement data.