Over-Implied Models from CO2 Emission Allowance Futures Option Market

Abstract

This study examines the empirical performance of emission allowance option pricing models, concentrating on the EU-ETS markets. For option pricing, we use parameters estimated from option market data whereas few papers in the extant literature use parameters from underlying asset data. As results, it is shown that the most appropriate is the one-factor model in which the EUA logarithmic spot prices follow the mean-reverting process of Ornstein-Uhlenbeck type. Also, the addition of jumps is not shown to make any significant improvement in the model performance. These results are quite striking in the sense that existing papers report the addition of jumps is necessary to improve option pricing on the EU-ETS markets. In sum, this paper is meaningful in the sense that it extends the growing empirical literature on the behavior of emission allowance spot prices