TY - CHAP
T1 - Empirical performance of the constant elasticity variance option pricing model
AU - Chen, Ren Raw
AU - Lee, Cheng Few
AU - Lee, Han Hsing
N1 - Publisher Copyright:
© 2024 World Scientific Publishing Company. All rights reserved.
PY - 2024/4/8
Y1 - 2024/4/8
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, Cao and Chen (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-ofthe- 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, Cao and Chen (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-ofthe- 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 - Finite difference method of the SV model
KW - Numerical experiment
KW - Option pricing model
KW - Stochastic volatility option pricing model
UR - http://www.scopus.com/inward/record.url?scp=85201453124&partnerID=8YFLogxK
U2 - 10.1142/9789811269943_0086
DO - 10.1142/9789811269943_0086
M3 - Chapter
AN - SCOPUS:85201453124
SN - 9789811269936
VL - 4-4
SP - 2751
EP - 2794
BT - Handbook Of Investment Analysis, Portfolio Management, And Financial Derivatives (In 4 Volumes)
PB - World Scientific Publishing Co.
ER -