Heterogeneous Basket Options Pricing Using Analytical Approximations

Abstract

This paper proposes the use of analytical approximations to price an heterogeneous basket option combining commodity prices, foreign currencies and zero-coupon bonds. We examine the performance of three moment matching approximations: inverse gamma, Edgeworth expansion around the lognormal and Johnson family distributions. Since there is no closed-form formula for basket options, we carry out Monte Carlo simulations to generate the benchmark values. We perform a simulation experiment on a whole set of options based on a random choice of parameters. Our results show that the lognormal and Johnson distributions give the most accurate results.

Keywords: Basket Options, Options Pricing, Analytical Approximations, Monte Carlo Simulation

JEL Classification: C15, C16, G10, G13