Pricing Commodity Swaptions in Multifactor Models

Abstract

The menu of swaps available in the market today ranges far beyond the basic fixed-for-floating interest rateswap. Commodity swaps specifying a series of future cash flows, whereby one counterparty pays a fixed dollar amount and the other pays the price appreciation on some underlying commodity, are a prime example. And if commodity swaps become popular, commodity swaptions will naturally be introduced. But valuing commodity swaptions involves modeling the behavior of both future interest rates and future commodity prices for all of the payment dates. The standard approach is Monte Carlo simulation, which is complicated and time consuming. Here, Larsson introduces an approximation that is quite mild in terms of the error it introduces and for which the execution time for a given level of accuracy is improved by several orders of magnitude.