Re-projecting volatility for European carbon option pricing

This paper’s main purpose applying multifactor stochastic volatility models is to analyse option pricing and study identify any microstructure differences between synchronous European carbon financial markets. The paper shows re-projected, Black’76 and market implied volatilities, identifies risk premiums from the underlying asset stochastic volatility, and reports the mean percentage pricing errors (MPE/MAPE) in the markets. The differences should add insights to market participants for any commodity market. The markets first major difference is the width of the strike contracts. The contract moneyness is much wider for the InterContinental Exchange followed by a more visible volatility smile. Furthermore, for both markets, the volatility and in particular the volatility smile seems to grow towards maturity. Finally, the mean relative errors for the re-projected volatility shows stable and almost unchanged (decreasing) errors towards maturity, while the Black’76 model reports unstable and almost explosive errors. The risk premiums show quite similar characteristics with a weekly correlation of about 96%.