The Additive Bachelier model with an application to the oil option market in the Covid period
Abstract
In April 2020, the Chicago Mercantile Exchange temporarily switched the pricing formula for West Texas Intermediate oil market options from the Black model to the Bachelier model. In this context, we introduce an Additive Bachelier model that provides a simple closed-form solution and a good description of the Implied volatility surface. This new Additive model exhibits several notable mathematical and financial properties. It ensures the no-arbitrage condition, a critical requirement in highly volatile markets, while also enabling a parsimonious synthesis of the volatility surface. The model features only three parameters, each one with a clear financial interpretation: the volatility term structure, vol-of-vol, and a parameter for modelling skew. The proposed model supports efficient pricing of path-dependent exotic options via Monte Carlo simulation, using a straightforward and computationally efficient approach. Its calibration process can follow a cascade calibration: first, it accurately replicates the term structures of forwards and At-The-Money volatilities observed in the market; second, it fits the smile of the volatility surface. Overall this model provides a robust and parsimonious description of the oil option market during the exceptionally volatile first period of the Covid-19 pandemic.