I am attempting to create a volatility surface for a US electricity market that has a liquid futures market but nearly non-existent options market (<5 trades per month across all strikes and expiration dates). Options in the natural gas market for the region are not particularly liquid either -- and, even so, natural gas is used only a few months out of the year. Is this exercise feasible? Where would be a good place to start? Thank you for your time and assistance!
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The three ways to manufacture pseudo-implied vols I know of are:
- Find a related underlying and, even if only few options trade on it, 'borrow' its implied vols.
- Compute statistical vol from historical underlying prices (not strike dependent, still useful to know).
- Compute breakeven vol, still based on historical underlying prices, strike dependent, by simulating terminal PnL for delta-hedged options with various strikes and expiry times and finding the vol that makes it null. See this reference and references therein (in particular Bruno Dupire's ones which I can't findon the net).
The 'borrowing' can be refined: one can always have statistical and breakeven vols for any underlying, so we just want to get the 'spreads' (ATM and wings) against the implied vols for the proxy underlying (if available).
