Valuation of a locational spread option: the case of tomatoes in Nairobi and Mombasa Counties in Kenya

Abstract

Locational Spread Options are financial instruments that can be used by traders wishing to purchase but not physically acquire produce; to hedge their risks, and / or to take speculative positions, based on their knowledge of market dynamics. In this study, we analyze historical tomato price data in Nairobi & Mombasa counties in Kenya; and observe that the Ornstein Uhlenbeck process best captures the price dynamics due to the mean reverting characteristics noted in the deseasonalized price data. We then derive pricing equations and estimate the model parameters via the use of Maximum Likelihood Estimation. Finally, we use these parameter estimations to perform Monte Carlo simulations, using the antithetic variate variance reduction technique to obtain the option price.