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

2026-07-21

AI Summary

This study addresses the challenge of constructing an implied volatility surface for Gasoil options due to insufficient market liquidity. To overcome this limitation, the authors propose a data-driven framework that jointly models Brent and Gasoil futures prices, leveraging information from the highly liquid Brent options market to infer Gasoil implied volatilities. The approach integrates cluster analysis of historical crack spreads and volatility differentials, a mixture-of-normals diffusion process, and a correlated Bachelier local volatility model, with Monte Carlo simulation employed to calibrate the volatility mapping from Brent to Gasoil. Empirical results demonstrate that the resulting Gasoil implied volatility surface closely aligns with observed market data, confirming the framework’s effectiveness and novelty in pricing energy derivatives.

Abstract

The Gasoil options market is illiquid, making it difficult to construct its implied volatility surface directly. However, it is closely linked to the highly liquid Brent options market. In this paper, we jointly model Brent and Gasoil futures prices through a correlated Bachelier local volatility model: the Brent factor is described by a normal mixture diffusion model, while the Gasoil-Brent spot volatility spread is estimated using a data-driven procedure that identifies clusters of historical crack-spread levels and Gasoil-Brent volatility spreads. The resulting bivariate model allows us to compute an implied volatility correction that maps Brent implied volatilities to Gasoil implied volatilities without using illiquid Gasoil option prices as inputs. Monte Carlo simulations demonstrate that the resulting implied volatilities closely match observed Gasoil implied volatilities when benchmarked against more direct approaches. These results suggest that the proposed framework is well suited for modeling refined products and pricing the corresponding financial derivatives.

Problem

• illiquid assets
• implied volatility surface
• energy markets
• option pricing
• benchmarking

Innovation

• local volatility model
• data-driven clustering
• implied volatility mapping
• illiquid asset pricing
• correlated Bachelier model