Do Volatility Smiles Matter for Pricing Asian Basket Options? The Case of Livestock Gross Margin Insurance for Dairy Cattle

By M. Bozic, J. Newton, C.S. Thraen, B.W. Gould

Livestock Gross Margin Insurance for Dairy Cattle (LGM-Dairy) is Asian basket option-like insurance tool that enables U.S. dairy producers to protect income-over-feed-costs margins. While LGM-Dairy rating method assumes flat implied volatility curves for all marginal price distributions, substantial evidence suggests upward-bending skews in implied volatility curves are typical and expected features of options written on futures for storable commodities. While volatility smiles and skews influence premiums considerably when there is only one source of risk, the basket option nature of LGM-Dairy suffices to make the lognormality assumption a useful heuristic that does not bias LGM-Dairy premiums in a financially important way.

Date published: 
Monday, October 1, 2012