Comparison of the Variance and Pricing Models

In this study, we test the empirical pricing performance of Constant–Elasticity-of-Variance (CEV) option pricing model by Cox (1975, 1996) and Cox and Ross (1976) and compare the future results with those by Bakshi, Cao and Chen (1997). CEV model, introducing only one more parameter compared with Black-Scholes formula, improves the performance notably in all the tests of in-future future sample, out-of-future future sample and the stability of implied volatility. Furthermore, with a much simpler model, the CEV model can still performs better than the stochastic volatility model in short term and out-of-the-money categories. The empirical evidence also shows that the CEV model has similar stability of implied volatility those models tested by Bakshi, Cao and Chen (1997). Therefore, with much less implementation cost and faster computational speed, the CEV option pricing model can be a better candidate than much more complex option pricing models, especially when one wants to apply CEV process for pricing more complicated path-dependent options or credit risk models.

Keywords:

Pricing Model , Financial Market , risk models