Valuing Time-Dependent CEV Barrier Options
Journal of Applied Mathematics and Decision Sciences, pp. 1-17, 2009
20 Pages Posted: 29 Mar 2008 Last revised: 10 Aug 2009
Date Written: June 1, 2009
In this paper we have derived the analytical kernels of the pricing formulae of the CEV knockout options with time-dependent parameters for a parametric class of moving barriers. By a series of similarity transformations and changing variables, we are able to reduce the pricing equation to one which is reducible to the Bessel equation with constant parameters. These results enable us to develop a simple and efficient method for computing accurate estimates of the CEV single-barrier option prices as well as their upper and lower bounds when the model parameters are time-dependent. By means of the multi-stage approximation scheme, the upper and lower bounds for the exact barrier option prices can be efficiently improved in a systematic manner. It is also natural that this new approach can be easily applied to capture the valuation of other standard CEV options with specified moving knockout barriers. In view of the CEV model being empirically considered to be a better candidate in equity option pricing than the traditional Black-Scholes model, more comparative pricing and precise risk management in equity options can be achieved by incorporating term-structures of interest rates, volatility and dividend into the CEV option valuation model.
Keywords: CEV option, similarity transformation, Bessel equation, moving barrier
JEL Classification: G13
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