Empirical Performance of the Constant Elasticity Variance Option Pricing Model

Review of Pacific Basin Financial Markets and Policies, Forthcoming

Posted: 22 Apr 2010 Last revised: 4 May 2010

See all articles by Ren-Raw Chen

Ren-Raw Chen

Fordham University - Gabelli School of Business

Cheng-Few Lee

Rutgers University, Newark, School of Business-Newark, Department of Finance & Economics

Han-Hsing Lee

National Chiao-Tung University

Abstract

In this essay, we empirically test the Constant-Elasticity-of-Variance (CEV) option pricing model by Cox (1975, 1996 [note: A revised version of the paper was published by the Journal of Portfolio Management (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.

Keywords: Constant-Elasticity-of-Variance (CEV) Process, Option Pricing Model, Empirical Performance, Numerical Experiment

Suggested Citation

Chen, Ren-Raw and Lee, Cheng-Few and Lee, Han-Hsing, Empirical Performance of the Constant Elasticity Variance Option Pricing Model. Review of Pacific Basin Financial Markets and Policies, Forthcoming. Available at SSRN: https://ssrn.com/abstract=1487910

Ren-Raw Chen (Contact Author)

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
Bronx, NY 10458
United States

Cheng-Few Lee

Rutgers University, Newark, School of Business-Newark, Department of Finance & Economics ( email )

111 Washington Avenue
Newark, NJ 07102
United States
732-445-3907 (Phone)
732-445-5927 (Fax)

Han-Hsing Lee

National Chiao-Tung University ( email )

Hsinchu 300
Taiwan

Register to save articles to
your library

Register

Paper statistics

Abstract Views
751
PlumX Metrics