Constant Elasticity of Variance (CEV) Option Pricing Model:Integration and Detailed Derivation

Constant Elasticity of Variance (CEV) Option
Pricing Model:Integration and Detailed Derivation

Ying-Lin Hsu
Department of Applied Mathematics
National Chung Hsing University
Co-authors: T. I. Lin and C. F. Lee
Oct. 21, 2008
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
1 / 46
Outline
Introduction
Transition Probability Density Function
Noncentral Chi-Square Distribution
The Noncentral Chi-Square Approach to Option Pricing Model
Detailed Derivations of C1 and C2
Approaches to 2
Some Computational Considerations
Special Cases
Concluding Remarks
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
2 / 46
Introduction
CEV model
The CEV option pricing model is defined as
dS = Sdt + S /2 dZ,
< 2,
where dZ is a Wiener process and is a positive constant.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
3 / 46
Introduction
The elasticity is 2 since the return variance (S, t) = 2 S 2 with

respect to price S has the following relationship
d(S, t)/dS
= 2,
(S, t)/S
which implies that d(S, t)/(S, t) = ( 2)dS/S.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
4 / 46
Introduction
If = 2, then the elasticity is zero and the stock prices are lognormally
distributed as in the Black and Scholes model (1973).
If = 1, then the elasticity is -1. The model proposed by Cox and Ross
(1976).
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
5 / 46
Introduction
We will focus on the case of < 2 since many empirical evidences

(see Campbell (1987), Glosten et al. (1993), Brandt and Kang (2004))
have shown that the relationship between the stock price and its return
volatility is negative. The transition density for > 2 is given by
Emanuel and Macbeth (1982)
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
6 / 46
Consider the constant elasticity of variance diffusion,

dS = (S, t) + (S, t)dZ,
where (S, t) = rS aS, and (S, t) = S /2 ,
0 < 2. Then
dS = (r a)Sdt + S /2 dZ.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
7 / 46
Let Y = Y (S, t) = S 2 . By Itos Lemma with

Y
= (2 )S 1 ,
S
Y
= 0,
t
2Y
= (2 )(1 )S ,
S 2
we have
i
h
1
dY = (r a)(2 )Y + 2 ( 1)( 2) dt + 2 (2 )2 Y dZ.
2
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
8 / 46
The Kolmogorov forward equation for Y becomes

n
o
1 2
P
1 2 2
(ra)(2)Y
+
=
(2
)Y
P
(1)(2)
P .
t
2 Y 2
Y
2
Then f (ST | St , T > t) = f (YT | yt , T > t) | J | where J = (2 )S 1 .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
9 / 46
By Fellers Lemma with a = 21 2 (2 )2 , b = (r a)(2 ),

h = 12 2 ( 2)(1 ), x = 1/T , x0 = 1/t and t = = (T t), we have
f (ST | St , T > t) = (2)k1/(2) (xz 1 )1/(2(2)) exz I1/(2) (2(xz)1/2 )

where
k =
2(r a)
,
2 (2 )[e(ra)(2) 1]
Ying-Lin Hsu (NCHU)
x = k St2 e(ra)(2) ,
z = k ST2 .
Oct. 21, 2008
10 / 46
Cox (1975) obtained the following option pricing formula:

x n
X
e x G n + 1 + 1/(2 ), k K 2
C = St e
(n + 1)
n=0

x n+1/(2)
X
e x
G n + 1, k K 2
r

Ke
,
n + 1 + 1/(2 )
n=0
r
R
where G(m, ) = ((m))1 eu um1 du is the standard
complementary gamma distribution function.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
11 / 46
If Z1 , . . . , Z are standard normal random variables, and 1 , . . . , are

constants, then
X
(Zi + i )2
Y =
i=1
is the noncentral Chi-square distribution

with degrees of freedom
P
2
2
and noncentrality parameter = j=1 j , and is denoted as ().
When j = 0 for all j, then Y is distributed as the central Chi-square
distribution with degrees of freedom, and is denoted as 2 .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
12 / 46
The cumulative distribution function of () is

2
F (x; , ) = P ( () x)
Z x
X
y
(/2)j
/2
y /2+j1 e 2 dy,
= e
/2
j!2 (/2 + j) 0
j=0
Ying-Lin Hsu (NCHU)
x > 0.
Oct. 21, 2008
13 / 46
An alternative expression for F (x; , ) is

F (x; , ) =
X
j=0
(/2)j e/2
j!
P (2+2j x).
2
The complementary distribution function of () is

Q(x; , ) = 1 F (x; , ).
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
14 / 46
The probability density function of () can be expressed as a

mixture of central Chi-square probability density functions.
p2 () (x) = e/2
Ying-Lin Hsu (NCHU)
X
( 1 )j
2
j!
j=0
(x+)/2
X
e
2/2
j=0
p2+2j (x)
x/2+j1 j
.
(/2 + j)22j j!
Oct. 21, 2008
15 / 46
An alternative expression for the probability density function of () is

1 x (2)/4
1
p2 () (x) =
exp ( + x) I(2)/2 ( x), x > 0,
2
2
where Ik is the modified Bessel function of the first kind of order k and
is defined as
j
k X
z 2 /4
1
z
.
Ik (z) =
2
j!(k + j + 1)
j=0
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
16 / 46
Following Schroder (1989) with the transition probability density

function, the option pricing formula under the CEV model is

C = E max(0, ST K) ,
= T t
Z
= er
f (ST | St , T > t)(ST K)dST
Z
ZK
r
r
= e
f (ST | St , T > t)dST
ST f (ST | St , T > t)dST e K
K
= C1 C2 .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
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Making the change of variable w = k ST2 , we have

dST = (2 )1 k 1/(2) w(1)/(2) dw.
Let y = k K 2 .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
18 / 46
exw (x/w)1/(42) I 1 (2 xw)(w/k )1/(2) dw

2
y
Z
= er (x/k )1/(2)
exw (x/w)1/(42) I 1 (2 xw)dw
2
y
Z
= er St e(ra)
exw (w/x)1/(42) I 1 (2 xw)dw
2
y
Z
exw (w/x)1/(42) I 1 (2 xw)dw,

= ea St
r
C1 = e
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
19 / 46
C2 = Ke
x 42 w(12+22)/(42) exw I
= Ker
Ying-Lin Hsu (NCHU)
exw (x/w)1/(4) I
1
2
1
2
(2 xw)dw
(2 xw)dw.
Oct. 21, 2008
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Recall that the probability density function of the noncentral Chi-square

distribution with noncentrality and degree of freedom is
1
(x/)(2)/4 I(2)/2 ( x)e(+x)/2
2
= P (x; , ).
p2 () (x) =
Let Q(x; , ) =
Ying-Lin Hsu (NCHU)
p2 () (y)dy. Then letting w = 2w and x = 2x.
Oct. 21, 2008
21 / 46
C1 = St e
= St e
= St e
Z
Z
e(x+w)/2
w 1/(42)
(x +w )/2
2y
1
2
!1/(42)
Q(2y; , x ),

2
a
= St e Q 2y; 2 +
, 2x ,
2
Ying-Lin Hsu (NCHU)

2 xw dw
1
2

1
dw
2 x w
2
Oct. 21, 2008
22 / 46
= Ker
C2 = Ke
e(x
x 1/(42)
w
+w )/2
2y
= Q 2y; 2
Ying-Lin Hsu (NCHU)
exw
2
, 2x
2
x
w
1
2
!1/(42)

2 xw dw
I
1
2

1
2 xw
dw
2
Oct. 21, 2008
23 / 46
Thus,
C = St ea Q(2y; 2 +
2
2
, 2x) Ker Q(2y; 2
, 2x).
2
2
It is noted that 2 2/(2 ) can be negative for < 2. Thus further

work is needed.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
24 / 46
Using the monotone convergence theorem and the integration by

parts, we have
Z
P (2y; 2, 2k)dk
=
=
n=0
n=0
1 X
ezk (z/k)1 kz
ez z n+1
(n + )
n=0
k
n
e k
(n + 1)
(zk)n
dk
n!(n + 1 + 1)
dk
g(n + , z)G(n + 1, y)
g(n + 1, z)
Ying-Lin Hsu (NCHU)
g(i, y).
i=1
Oct. 21, 2008
25 / 46
G(n, y) =
ek kn1
dk
(n)
kn1 k
de
(n)
y
Z n2 k
k
e
y n1 ey
+
dk
=
(n)
(n 1)
y
n
X
y i1 ey
=
(i)
=
i=1
n
X
g(i, y).
i=1
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
26 / 46
Next, applying the monotone convergence theorem, we have
=
=
=
=
=
Q(z; , k)
Z
p
1 y (2)/4
ky e(k+y)/2 dy
I 2
2
2
k
z
(2)/2 X

Z
(ky/4)n (k+y)/2
1 y (2)/4 1 p
e
ky
dy
2 k
2
n! +2n
z
2
n=0

+2n
n 1 n Z
X
ey/2 y 2 1
k/2 k
2
e

dy
1 (+2n)/2
+2n
(n + 1) z
n=0
2
2
n Z
(+2n)/2
X
+2n
(1/2)
(k/2)
ey/2 y 2 1 dy
ek/2
+2n
(n + 1) z
2
n=0
ek/2
n=0
Ying-Lin Hsu (NCHU)
(k/2)n
Q(z; + 2n, 0),
(n + 1)
Oct. 21, 2008
27 / 46
where
(1/2)(+2n)/2 y/2 +2n 1
e
dy
y 2
+2n
z
2
Z
+2n
1
y 2 1 dy
=
+2n e y
z/2
2
= G (n + /2, z/2) .
Q(z; + 2n, 0) =
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
28 / 46
Furthermore
Q(z; , k) =
=
n=0
n=0
g (n + 1, k/2) G (n + /2, z/2)

2
g (n, k/2) G n +
, z/2 .
2
Hence
Q(2z; 2, 2k) =
n=0
Ying-Lin Hsu (NCHU)
g (n, k) G (n + 1, z) .
Oct. 21, 2008
29 / 46
Again
Q(2z; 2, 2k)
= g (1, k) G (, z) + g (2, k) G ( + 1, z) + g (3, k) G ( + 2, z) +
= g (1, k) [G ( 1, z) + g (, z)] + g (2, k) [G ( 1, z) + g ( + 1, z)]

+g (3, k) [G ( 1, z) + g (, z) + g ( + 1, z) + g ( + 2, z)] +
= G ( 1, z) + g (, z) + g ( + 1, z) [1 g (1, k)]
+g ( + 2, z) [1 g (1, k) g (2, k)] +
X
g ( + n, z) g ( + 1, z) [g (1, k)]
= G ( 1, z) +
n=0
g ( + 2, z) [g (1, k) + g (2, k)] +
= 1 g ( + 1, z) [g (1, k)]
g ( + 2, z) [g (1, k) + g (2, k)] .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
30 / 46
We conclude that
Q(2z; 2, 2k) = 1
And
n=1
g (n + , z)
n
X
g (i, k) .
i=1
P (2z; 2, 2k)dk = 1 Q (2z; 2( 1), 2y) .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
31 / 46
Thus
C2

2
, 2w dw
= Ke
P 2x; 2 +
2
y

2
r
= Ke Q 2y; 2
, 2x
2

2
r
= Ke
1 Q(2x;
, 2y) .
2
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
32 / 46
We obtain
a
C = St e
2
, 2x) Ker
Q(2y; 2 +
2

2
, 2y) ,
1 Q(2x;
2
where y = k K 2 , x = k St2 e(ra)(2),

k = 2(r a)/ 2 (2 )(e(ra)(2) 1) and a is the continuous
proportional dividend rate.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
33 / 46
When > 2 (see, Emanuel and MacBeth (1982), Chen and Lee
(1993)), the call option formula is as follows:

2
2
r
a
, 2y) Ke
, 2x) .
1 Q(2y; 2 +
C = St e Q(2x;
2
2
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
34 / 46
Approaches to 2
We consider that the noncentral Chi-square distribution will approach

log-normal as tends to 2. Since when either or approaches to
infinity, the standardized variable
2
() ( + )
p
2( + 2)
tends to N(0,1) as either or .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
35 / 46
Approaches to 2
lim
lim
() ( + )
p
2( + 2)
2k ST2 ( + )
p
2( + 2)
2r ST2 (1 ) 2 (er (2) 1) 2r St2 er

= lim
2
2 (er (2) 1)
s
2 (er (2) 1)/(2 )
(1 ) 2 (er (2) 1) + 4r St2 er (2)

=
(2)
ln ST [ln St + (r 2 /2) ]
where r = r a.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
36 / 46
Approaches to 2
Thus,
ln ST | ln St N (ln St + (r a 2 /2), 2 )
as 2 . Similarly, it also holds when 2+ . And we also obtain

the same result for > 2.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
37 / 46
First initialize the following four variables (with n = 1)

gA =
ez z
= g(1 + , z),
(1 + )
gB = ek = g(1, k),
Sg = gB,
R = 1 (gA)(Sg).
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
38 / 46
Then repeat the following loop beginning with n = 2 and increase

increment n by one after each iteration. The loop is terminated when
the contribution to the sum, R, is declining and is very small.

z
gA = gA
= g(n + , z),
n+ 1

k
= g(n, k),
gB = gB
n1
Sg = Sg + gB = g(1, k) + g(n, k)
R = R (gA)(Sg) = the nth partial sum.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
39 / 46
As each iteration, gA equals g(n + , z), gB equals g(n, k) and Sg

equals g(1, k) + + g(n, k). The computation is easily done.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
40 / 46
Using the approximation

2
Q(z; , k) = P r( > z)
!
2
z
= Pr
>
+k
+k
!
h

h
2
z
>
= Pr
+k
+k

h
z
1
hP
[1
h
+
0.5(2
h)mP
]
+k
p
=
,
h 2P (1 + mP )
where h = 1 23 ( + k)( + 3k)( + 2k)2 , P = ( + 2k)/( + k)2 and

m = (h 1)(1 3h).
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
41 / 46
Q(z, 1, k) =
Special Cases
fY (y)dy
= 1 FY (z)
= 1 P (Y z)
= 1 P (z + )2 z
= 1 P (|z + | z)
= 1 P ( z z + z)
= 1 [N ( z ) N ( z)]
= N ( z k) + 1 N ( z k)
= N ( k z) + N ( k z).
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
42 / 46
Q(z, 3, k) = Q(z, 1, k) +
= Q(z, 1, k) +
= Q(z, 1, k) +
= Q(z, 1, k) +
= Q(z, 1, k) +
= Q(z, 1, k) +
Ying-Lin Hsu (NCHU)
Special Cases
1 X (k/4)j z j+ 2
e(k+z)/2
2 j=0 j! 21 + j + 1
2j+1
2 1 X (kz)1/2

e(k+z)/2
2 k j=0 (2j + 1)!

X
1
( kz)2j+1 (k+z)/2

e
k 2 j=0 (2j + 1)!

1
1
1
e kz e kz e(z+k)/2
2
2
k

1
1 (k+z)2 /2
1 (kz)2 /2
e
e
2
2
k
i
1 h
N ( k z) N ( k + z) .
k
Oct. 21, 2008
43 / 46
Special Cases
Q(z; 5, k)
i
= Q(z; 1, k) + k1/2 N ( k z) N ( k + z)
+(k1 z k3/2 )N ( k z) + (k1 z + k3/2 )N ( k + z)
= Q(z; 1, k) + (k1/2 k3/2 + k1 z)N ( k z)
(k1/2 1 k1 z)N ( k + z)
= Q(z; 1, k)
h
i
3
+k 2 (k 1 + kz)N ( k z) (k 1 kz)N ( k + z) .
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
44 / 46
Concluding Remarks
The option pricing formula under the CEV model is quite complex
because it involves the cumulative distribution function of the
noncentral Chi-square distribution Q(z; , k).
Some computational considerations are given in the article which

will facilitate the computation of the CEV option pricing formula.
We can use the function pchisq(q, df , ncp) in free software R to

calculate the cumulative distribution function of the noncentral
Chi-square distribution, where q is the quantile, df is the degree of
freedom which non-integer values are allowed and ncp is the
noncentrality parameter.
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
45 / 46
Concluding Remarks
THE END.
Thanks For Your Attentions!
Ying-Lin Hsu (NCHU)
Oct. 21, 2008
46 / 46

Constant Elasticity of Variance (CEV) Option Pricing Model:Integration and Detailed Derivation

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Constant Elasticity of Variance (CEV) Option Pricing Model:Integration and Detailed Derivation

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Constant Elasticity of Variance (CEV) Option

Pricing Model:Integration and Detailed Derivation

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

where dZ is a Wiener process and is a positive constant.

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

The elasticity is 2 since the return variance (S, t) = 2 S 2 with

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

We will focus on the case of < 2 since many empirical evidences

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Transition Probability Density Function

Consider the constant elasticity of variance diffusion,

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Transition Probability Density Function

Let Y = Y (S, t) = S 2 . By Itos Lemma with

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Transition Probability Density Function

The Kolmogorov forward equation for Y becomes

Then f (ST | St , T > t) = f (YT | yt , T > t) | J | where J = (2 )S 1 .

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Transition Probability Density Function

By Fellers Lemma with a = 21 2 (2 )2 , b = (r a)(2 ),

f (ST | St , T > t) = (2)k1/(2) (xz 1 )1/(2(2)) exz I1/(2) (2(xz)1/2 )

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Transition Probability Density Function

Cox (1975) obtained the following option pricing formula:

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Noncentral Chi-Square Distribution

If Z1 , . . . , Z are standard normal random variables, and 1 , . . . , are

is the noncentral Chi-square distribution

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Noncentral Chi-Square Distribution

The cumulative distribution function of () is

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Noncentral Chi-Square Distribution

An alternative expression for F (x; , ) is

The complementary distribution function of () is

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Noncentral Chi-Square Distribution

The probability density function of () can be expressed as a

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

Noncentral Chi-Square Distribution

An alternative expression for the probability density function of () is

Ying-Lin Hsu (NCHU)

Oct. 21, 2008

The Noncentral Chi-Square Approach to Option Pricing Model