Valuation of Standard Options under the Constant Elasticity of Variance Model
AbstractA binomial model is developed to value options when the underlying process follows the constant elasticity of variance (CEV) model. This model is proposed by Cox and Ross (1976) as an alternative to the Black and Scholes (1973) model. In the CEV model, the stock price change (dS) has volatility £mS £]/2 instead of £mS in the Black-Scholes model. The rationale behind the CEV model is that the model can explain the empirical bias exhibited by the Black-Scholes model, such as the volatility smile. The option pricing formula when the underlying process follows the CEV model is derived by Cox and Ross (1976), and the formula is further simplified by Schroder (1989). However, the closed-form formula is useful in some limited cases. In this paper, a binomial process for the CEV model is constructed to yield a simple and efficient computation procedure for practical valuation of standard options. The binomial option pricing model can be employed under general conditions. Also, on average, the numerical results show the binomial option pricing model approximates better than other analytic approximations.
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Bibliographic InfoArticle provided by College of Business, and College of Finance, Feng Chia University, Taichung, Taiwan in its journal International Journal of Business and Economics.
Volume (Year): 4 (2005)
Issue (Month): 2 (August)
binomial model; constant elasticity of variance model; option pricingtakeovers;
Find related papers by JEL classification:
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
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- Schroder, Mark Douglas, 1989. " Computing the Constant Elasticity of Variance Option Pricing Formula," Journal of Finance, American Finance Association, vol. 44(1), pages 211-19, March.
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