TY - JOUR

T1 - Empirical performance of the constant elasticity variance option pricing model

AU - Chen, Ren Raw

AU - Lee, Cheng Few

AU - Lee, Han-Hsing

PY - 2009/8/13

Y1 - 2009/8/13

N2 - In this essay, we empirically test the Constant-Elasticity-of-Variance (CEV) option pricing model by Cox (1975, 1996) and Cox and Ross (1976), and compare the performances of the CEV and alternative option pricing models, mainly the stochastic volatility model, in terms of European option pricing and cost-accuracy based analysis of their numerical procedures. In European-style option pricing, we have tested the empirical pricing performance of the CEV model and compared the results with those by Bakshi et al. (1997). The CEV model, introducing only one more parameter compared with Black-Scholes formula, improves the performance notably in all of the tests of in-sample, out-of-sample and the stability of implied volatility. Furthermore, with a much simpler model, the CEV model can still perform better than the stochastic volatility model in short term and out-of-the-money categories. When applied to American option pricing, high-dimensional lattice models are prohibitively expensive. Our numerical experiments clearly show that the CEV model performs much better in terms of the speed of convergence to its closed form solution, while the implementation cost of the stochastic volatility model is too high and practically infeasible for empirical work. In summary, with a much less implementation cost and faster computational speed, the CEV option pricing model could be a better candidate than more complex option pricing models, especially when one wants to apply the CEV process for pricing more complicated path-dependent options or credit risk models.

AB - In this essay, we empirically test the Constant-Elasticity-of-Variance (CEV) option pricing model by Cox (1975, 1996) and Cox and Ross (1976), and compare the performances of the CEV and alternative option pricing models, mainly the stochastic volatility model, in terms of European option pricing and cost-accuracy based analysis of their numerical procedures. In European-style option pricing, we have tested the empirical pricing performance of the CEV model and compared the results with those by Bakshi et al. (1997). The CEV model, introducing only one more parameter compared with Black-Scholes formula, improves the performance notably in all of the tests of in-sample, out-of-sample and the stability of implied volatility. Furthermore, with a much simpler model, the CEV model can still perform better than the stochastic volatility model in short term and out-of-the-money categories. When applied to American option pricing, high-dimensional lattice models are prohibitively expensive. Our numerical experiments clearly show that the CEV model performs much better in terms of the speed of convergence to its closed form solution, while the implementation cost of the stochastic volatility model is too high and practically infeasible for empirical work. In summary, with a much less implementation cost and faster computational speed, the CEV option pricing model could be a better candidate than more complex option pricing models, especially when one wants to apply the CEV process for pricing more complicated path-dependent options or credit risk models.

KW - Constant-Elasticity-of-Variance (CEV) process

KW - Empirical performance

KW - Numerical experiment

KW - Option pricing model

UR - http://www.scopus.com/inward/record.url?scp=68349085553&partnerID=8YFLogxK

U2 - 10.1142/S0219091509001605

DO - 10.1142/S0219091509001605

M3 - Article

AN - SCOPUS:68349085553

VL - 12

SP - 177

EP - 217

JO - Review of Pacific Basin Financial Markets and Policies

JF - Review of Pacific Basin Financial Markets and Policies

SN - 0219-0915

IS - 2

ER -