The SD benchmark model utilizes a number of market data categories for pricing commodity options.
As far as volatility is concerned, the SuperDerivatives model requires three data inputs per tenor (maturity):
The at-the-money (ATM) volatility (or a close enough value), similarly to input required by Black & Scholes and other models.
One measure of skew (collar or risk reversal) and one measure of convexity (strangle or butterfly spread). The most liquid and “reasonable” strikes for each tenor are used by SD (apart from certain instruments such as metals, where the market has standardized 25 delta risk reversal and 25 delta butterfly, similar to the FX market).
These are the three measures of volatility which are considered the most liquid measures of each volatility and are freely available data in the markets. In addition to the ATM volatility, the special pair of option strategies it requires (whether collar and strangle or risk reversal and butterfly) are related to the re-hedging of the Vega, which reflects the change in the price that occurs from the change in the volatility. This is crucial for accurate pricing, as in the real market when the strike moves the price also moves.
This phenomenon is widely recognized in the market as the “volatility smile”, and any accurate pricing model must take this into account. Although Black & Scholes ignores any change in volatility and obviously any need to re-hedge this risk, the SuperDerivatives model takes the volatility smile into account, and can moreover calculate it for any asset from just the three market data points as listed above—ATM and two other additional liquid volatility parameters.
In addition, SDX Commodities & Energy utilizes the following market data:
ATMF straddle
Forward price
Spread to underlying
Deposit rate for the base currency