Spread Option Valuation
A spread option is an option whose payoff depends on the difference of two underling assets: S2(T) and S1(T). The buyer of a spread option has the right to be paid, at the maturity date T, the difference S2(T)−S1(T), known as the spread. To exercise the option, the buyer must pay at maturity a prespecified price K, known as the strike, or the exercise price of the option.
Spread options are instruments that provide a payoff dependent on the spread between two interest rates. In some cases, the rates are both calculated from the same yield curve. In other cases, two different yield curves are involved. To value a spread option, it is necessary to calculate the expected spread in a world that is forward risk neutral with respect to a zero-coupon bond maturing at the time the payoff occurs.
The use of spread options is widespread for hedge, speculation, and basis risk mitigation. Spread options allow investors to simultaneously take positions in two assets and profit from their price difference.
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