Basket Options on Heterogeneous Underlying Assets

Abstract

Basket options are among the most popular products of the new generation of exotic options. This attraction is explained by the fact that they can efficiently and simultaneously hedge a wide variety of intrinsically different financial risks. They are flexible enough to include all the risks faced by non-financial firms. Unfortunately, the existing literature on basket options considers only homogeneous baskets where all the underlying assets are identical and hedge the same kind of risk. Moreover, the empirical implementation of basket-option models is not yet well developed, particularly when they are composed of heterogeneous underlying assets. This paper focus on the modelization and the parameters estimation of basket options on commodity price with stochastic convenience yield, exchange rate, and domestic and foreign zero-coupon bonds in a stochastic interest rates setting. We empirically compare the performance of the heterogeneous basket option to that of a portfolio of individual options. The results show that the basket strategy is less expensive and more efficient. We apply the maximum-likelihood method to estimate the different parameters of the theoretical basket model as well as the correlations between the variables. Monte Carlo studies are conducted to examine the performance of the maximum-likelihood estimator in finite samples of simulated data. A real data study is presented.