Abstract

In this paper, we investigate the pricing of European crude oil options under nonlinear dynamics with stochastic behaviour and jump risks, incorporating the features of arising convenience yield of crude oil and potential extreme fluctuation in the dynamics of crude oil prices. We present a closed-form solution to European crude oil option prices under an incomplete market setting, after deriving the pricing kernel with the equilibrium method and determining the risk neutral dynamics of crude oil prices. We extend our model to a mean-reverting stochastic volatility case, which also admits an analytical formula for the equilibrium price of European crude-oil options. Finally, our model is shown to be consistent with a number of interesting facts documented in the recent literature.

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