Putting Smiles Back to the Futures Paper

This research paper "Putting Smiles Back to The Futures" describes a practical method to extend the classical log-normal Gabillon model to incorporate volatility smiles, and a forward market model for pricing options on Forward Freight Agreements (FFA) with a term structure of FFA volatility.

Gabillon Model with Volatility Smiles

The Gabillon model can effectively capture the difference in future curve volatility between the front- and back-ends of the curve. However, the Gabillon model ignores the effects of volatility smiles that are commonly observed in the options markets. Given their dependency on multiple points of the futures curve, the value of many commodity derivatives can be sensitive to the volatility smiles of futures prices. To effectively price and risk manage these products, we need to incorporate smile information into the correlation and term structure modeling of the futures curve.