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The Constant Elasticity of Variance Option

Pricing Model
John Randal
A thesis
submitted to the Victoria University of Wellington
in partial fullment of the
requirements for the degree of
Master of Science
in Statistics and Operations Research
April, 1998
2
Acknowledgements
The author would like to thank his supervisors, Peter Thomson and Martin
Lally, for their guidance and encouragement. Also, thanks to Credit Su-
isse First Boston NZ Limited for providing data, and to Edith Hodgen for
valuable assistance with the preparation of this document.
i
ii
Abstract
The Constant Elasticity of Variance (CEV) Model was rst presented in 1976
by John Cox and Stephen Ross as an extension to the famous Black-Scholes
European Call Option Pricing Model of 1972/3. Unlike the Black-Scholes
model, which is accessible to anyone with a pocket calculator and tables of
the standard normal distribution, the CEV solution consists of a pair of in-
nite summations of gamma density and survivor functions. Its derivation
rested on the risk-neutral pricing theory and the results of Feller. Moreover,
descriptions of this model in journal and text-book literature frequently con-
tained errors.
One diculty in implementation of the Black-Scholes model is that one
of its arguments is an unobserved parameter , the share price volatility.
Much research has concentrated on estimating this parameter with a general
conclusion that it is better to imply this volatility from observed option
prices, than to estimate it from stock price data. In the case of the CEV
model there are two unobserved parameters,
2
, with a relationship to the
Black-Scholes parameter, and , which denes the relationship between share
price level and the variance of the instantaneous rate of return on the share.
Attempts made to estimate this second parameter in the early 1980s were
not altogether satisfactory, perhaps condemning the CEV model to obscurity.
A breakthrough was made in 1989 with a paper by Mark Schroder, who
devised a method of evaluating the CEV option prices using the non-central
Chi-Squared probability distribution, hence facilitating signicantly simpler
computation of the prices for those with suitable statistical software
1
.
1
I use the statistical package SPLUS extensively in this thesis.
iii
iv
This thesis attempts to summarise the development of the CEV model,
with comparisons made to the industry standard, the Black-Scholes model.
The elegance of Schroders method is also made clear. Joint estimation of
the two parameters of the CEV model, and , is attempted using both
simulated data, and a sample of stocks traded on the Australian Stock Ex-
change. In this section, it appears that signicant improvements can be made
to earlier estimation methods.
Finally, I would like to note that this thesis is primarily a statistical
analysis of a nancial topic. As a consequence of this, the focus of my
analysis diers to that of articles in the nancial journal literature, and that
of nance texts. Furthermore, the literature on the CEV model is sparse,
and in general theorems therein are stated without proof. Some theorems
found in this thesis reect the statistical nature of the analysis and are hence
absent from the nancial literature which I have surveyed and referenced.
Throughout the thesis, I have attempted to make it clear when an idea
or proof follows previously established material. Unattributed material is
generally that which I have worked on with my supervisors guidance, but
which is not found in the references I have used.
Contents
1 Introduction to Options 1
1.1 The Call Option . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1.1 An example . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 The Value of Call Options . . . . . . . . . . . . . . . . . . . . 2
2 GBM and the Black-Scholes Model 9
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
2.2 Share Price Evolution . . . . . . . . . . . . . . . . . . . . . . . 10
2.2.1 Simulation of Geometric Brownian Motion . . . . . . . 15
2.2.2 The Future Share Price S
T
. . . . . . . . . . . . . . . . 18
2.3 Properties of C
T
- the Exercise Payo . . . . . . . . . . . . . . 20
2.3.1 Mean and Variance of C
T
given S
t
. . . . . . . . . . . 23
2.3.2 Simulation of C
T
. . . . . . . . . . . . . . . . . . . . . 25
2.4 The Black-Scholes Formula . . . . . . . . . . . . . . . . . . . . 25
2.4.1 Properties of Call Price Prior to Maturity . . . . . . . 32
2.4.2 Best Predictor of a Future Black-Scholes Price . . . . . 34
2.4.3 Graphical Examination of C
t
. . . . . . . . . . . . . . . 37
2.5 Use of the Black-Scholes Model . . . . . . . . . . . . . . . . . 42
3 The CEV Model 47
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
3.2 The CEV Share Price Solution . . . . . . . . . . . . . . . . . . 50
3.2.1 Solution of the Forward Kolmogorov Equation . . . . . 54
v
vi CONTENTS
3.2.2 Simulation of CEV Share Prices . . . . . . . . . . . . . 62
3.2.3 CEV Share Price Series . . . . . . . . . . . . . . . . . . 66
3.2.4 Graphical Examination of S
T
. . . . . . . . . . . . . . 71
3.3 Properties of C
T
- the Exercise Payo . . . . . . . . . . . . . . 77
3.4 The CEV Option Pricing Formula . . . . . . . . . . . . . . . . 78
3.4.1 The CEV Solution . . . . . . . . . . . . . . . . . . . . 81
3.4.2 Reconciling Various Forms of the CEV Solution . . . . 84
3.5 Computing the Option Price . . . . . . . . . . . . . . . . . . . 85
3.5.1 The Absolute CEV Model . . . . . . . . . . . . . . . . 85
3.5.2 Computing the General Model . . . . . . . . . . . . . . 86
3.5.3 CEV Option Prices . . . . . . . . . . . . . . . . . . . . 91
3.5.4 Behaviour of CEV Prices . . . . . . . . . . . . . . . . . 96
3.6 Use of the CEV Model . . . . . . . . . . . . . . . . . . . . . . 98
4 Data Analysis 105
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106
4.1.1 Summary of Alternative Methods . . . . . . . . . . . . 107
4.2 Estimating from a share price series . . . . . . . . . . . . . . 113
4.2.1 Estimation Strategy . . . . . . . . . . . . . . . . . . 114
4.2.2 The Variance of

. . . . . . . . . . . . . . . . . . . . . 120
4.3 Appraisal of the Estimation Technique . . . . . . . . . . . . . 122
4.4 Data Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . 129
5 Conclusions 141
A Denitions 143
B Proofs for Selected Results 147
B.1 Result 2.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
B.2 Result 3.2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
B.3 Result 3.4 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
B.4 Result 3.5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152
CONTENTS vii
C Complete List of Shares 155
D SPLUS Code 157
D.1 GBM Simulation . . . . . . . . . . . . . . . . . . . . . . . . . 157
D.2 Inversion of the Black-Scholes Formula . . . . . . . . . . . . . 158
D.3 CEV Share Price Simulation . . . . . . . . . . . . . . . . . . . 160
D.4 Estimation of . . . . . . . . . . . . . . . . . . . . . . . . . . 161
Bibliography 164
viii CONTENTS
List of Figures
1.1 The lower bounds for call option value, and a possible form
for the call price. . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.1 A realisation of GBM with initial value S
t
= $5, and parame-
ters = 0.1, = 0.3 and 250 subintervals. . . . . . . . . . . . 16
2.2 The daily returns for the series shown in Figure 2.1 with esti-
mated and actual mean, and the estimated mean 2 standard
deviation limits. . . . . . . . . . . . . . . . . . . . . . . . . . . 18
2.3 5000 realisations of S
T
, a future geometric Brownian motion
price, with initial value S
t
= $5, and parameters = 1, =
0.1 and = 0.3, and the theoretical lognormal distribution for
S
T
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
2.4 The unbroken series is a realisation of GBM with initial value
S
t
= $5 and parameters = 0.1, = 0.3, and 250 subin-
tervals; the second series is the Black-Scholes prices for this
share series added to the present value of the exercise price,
with K = $5, and r = 0.06 and maturity at T = 1 year; -
nally the smooth broken line represents the present value of
the exercise price. . . . . . . . . . . . . . . . . . . . . . . . . . 39
ix
x LIST OF FIGURES
2.5 The unbroken series is a realisation of GBM with initial value
S
t
= $5 and parameters = 0.1, = 0.3, and 250 subin-
tervals; the second series is the Black-Scholes prices for this
share series added to the present value of the exercise price,
with K = $5, and r = 0.06 and maturity at T = 1 year; -
nally the smooth broken line represents the present value of
the exercise price. . . . . . . . . . . . . . . . . . . . . . . . . . 40
2.6 The distribution of call prices obtained using the Black-Scholes
formula on a sample of share prices S
t+s
, where s = 1 year,
S
t
= $5, = 0.1, = 0.1, K = $5, r = 0.06 and time to
maturity s of 5 months. Also shown is the theoretical
density function. . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.7 The distribution of call prices obtained using the Black-Scholes
formula on a sample of share prices S
t+s
, where s = 1 year,
S
t
= $5, = 0.1, = 0.1, K = $5, r = 0.06 and time to
maturity s ranges from 2 years to half a month. Also the
theoretical density function for these prices. . . . . . . . . . . 45
2.8 The distribution of call prices obtained using the Black-Scholes
formula on a sample of share prices S
t+s
, where s = 1 year,
S
t
= $5, = 0.1, = 0.1, K = $5, r = 0.06 and time to
maturity s ranges from 2 to 75 years. Also the (solid)
theoretical density function for these prices, and the (dotted)
lognormal density function of S
t+s
. . . . . . . . . . . . . . . . 46
3.1 The relationship between and P(S
T
= 0), with S
t
= $5,
= 1 year, = 0.10, = S
/21
t
= 0.3 in the solid curve and
= 0.28 in the broken curve. . . . . . . . . . . . . . . . . . . 59
LIST OF FIGURES xi
3.2 Firstly, a typical realisation of GBM, with S
t
= $5, = 1 year,
= 0.10, = 0.3 and n = 250 subintervals; secondly, the
daily returns for this series with estimated mean, and mean
2 standard deviation series; thirdly, a plot of the share price
level against the estimated standard deviation of the daily
returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69
3.3 Firstly, a typical realisation of share price, with S
t
= $5, = 1
year, = 0.10, = 0.3 and n = 250 subintervals and CEV
parameter = 1; secondly, the daily returns for this series
with estimated mean, and mean 2 standard deviation series;
thirdly, a plot of the share price level against the estimated
standard deviation of the daily returns. . . . . . . . . . . . . . 70
3.4 5000 realisations of S
T
, a future CEV price with = 1,
with S
t
= $5, = 1 year, = 0.1 and = 0.3, the (solid)
theoretical density for these prices, and the lognormal density
function with the same parameters. . . . . . . . . . . . . . . . 74
3.5 The empirical cumulative distribution function of the 5000
realisations of S
T
shown in Figure 3.4, a future CEV price
with = 1, with parameters S
t
= $5, = 1, = 0.1 and
= 0.3, and the theoretical distribution function for these
prices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
3.6 The standard deviation of a future CEV share price S
T
, with
S
t
= $5, = 1 year, = 0.1 and = 0.3, for 2 2. . . . 76
3.7 A realisation of a CEV share price with initial value S
t
= $5,
and parameters = 1, = 1, = 0.1, = 0.3, and 250
subintervals; also the CEV option prices for this share series
added to the present value of the exercise price, with K = $5,
and r = 0.06 and time to maturity indicated on the horizontal
scale; nally the present value of the exercise price itself. . . . 92
xii LIST OF FIGURES
3.8 Black-Scholes implied volatilities for Absolute CEV option
prices with S
t
= $5, = 1 year, = 0.3, r = 0.06 and
$4 K $6. . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
3.9 Out-of-the-money CEV option prices, with between -2 and
6, between 0.4 and 2, and additional parameters S
t
= $50,
K = $55, = 0.5 years, and r = 0.06. . . . . . . . . . . . . . 101
3.10 At-the-money CEV option prices, with between -2 and 6,
between 0.4 and 2, and additional parameters S
t
= $50,
K = $50, = 0.5 years, and r = 0.06. . . . . . . . . . . . . . 102
3.11 In-the-money CEV option prices, with between -2 and 6,
between 0.4 and 2, and additional parameters S
t
= $50,
K = $45, = 0.5 years, and r = 0.06. . . . . . . . . . . . . . 103
4.1 The log-likelihood surface,

l(, ), for a simulated series with
S
t
= $5, = 3 years, = 0.1, = 0.3, n = 250 subintervals
per year, and = 0. . . . . . . . . . . . . . . . . . . . . . . . 119
4.2 The cross-section of the log-likelihood surface in Figure 4.1,

l(,

) for a simulated series with S


t
= $5, = 3 years, = 0.1,
= 0.3, n = 250 subintervals per year, and = 0. In addition,
the line =

which identies the maximum. . . . . . . . . . 119
4.3 e
n
, given by Equation (4.14), for the simulated series examined
previously with S
t
= $5, = 3 years, = 0.1, = 0.3,
n = 250 subintervals per year, and = 0. . . . . . . . . . . . . 123
4.4 Estimates of , resulting from CEV share price simulation,
used for the gures in Table 4.2. Superimposed on these are
the density function of an N(

, 1) random variable over the


range of the estimates, where

is the sample average of the
estimates. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124
4.5 Estimates of s(

), the standard deviation of



, from Table 4.2
against the true . . . . . . . . . . . . . . . . . . . . . . . . . 128
LIST OF FIGURES xiii
4.6 Sample values e
n
, dened in Equation (4.14), for the share
price of AMC, with superimposed N(0, 1) density function. . 133
4.7 The BHP share series; in addition, the daily returns for this
series with moving mean, and mean 2 standard deviation
series; thirdly, a plot of the share price level against standard
deviation of the daily returns. . . . . . . . . . . . . . . . . . . 137
4.8 The MIM share series; in addition, the daily returns for this
series with moving mean, and mean 2 standard deviation
series; thirdly, a plot of the share price level against standard
deviation of the daily returns. . . . . . . . . . . . . . . . . . . 138
4.9 The BOR share series; in addition, the daily returns for this
series with moving mean, and mean 2 standard deviation
series; thirdly, a plot of the share price level against standard
deviation of the daily returns. . . . . . . . . . . . . . . . . . . 139
xiv LIST OF FIGURES
List of Tables
3.1 A section of MacBeth and Mervilles Table 1, of CEV option
prices, calculated for the parameters shown, with additional
parameters: S
t
= $50 and r = 0.06. . . . . . . . . . . . . . . . 93
3.2 Beckers values (rounded to 4 d.p.) for the Square Root
CEV process, found using Equation (3.45), with additional
parameters S
t
= $40, and = log(1.05). . . . . . . . . . . . . 94
3.3 A section of Beckers Table II, showing Square Root CEV
prices, with additional parameters S
t
= $40, and r = log(1.05). 95
3.4 Beckers values (rounded to 4 d.p.) for the Absolute CEV
process, with additional parameters S
t
= $40, and = log(1.05). 96
4.1 MacBeth and Mervilles estimates for six stocks. . . . . . . . 110
4.2 Summary of the estimates for simulated series, obtained us-
ing the maximum likelihood procedure described above, with
S
t
= $5, = 0.1, = 0.3 and where 3 years data is used. . . . 126
4.3 p-values for hypothesis test H
0
: = i, i = 2, 1, . . . , 6
using the simulated data summarised in Table 4.2. . . . . . . . 127
4.4 estimates for the 44 ASX share series, with estimates of
s(

), the standard deviation of



, and the resulting condence
intervals obtained by simulation. . . . . . . . . . . . . . . . . . 130
4.5 p-values for the test of normality of e
n
for the 44 ASX share
series, where e
n
is given by Equation (4.14). . . . . . . . . . . 132
C.1 ASX Company Codes . . . . . . . . . . . . . . . . . . . . . . . 155
xv
xvi LIST OF TABLES
Chapter 1
Introduction to Options
1
2 CHAPTER 1. INTRODUCTION TO OPTIONS
1.1 The Call Option
A call option gives the holder the opportunity, but not the obligation, to
purchase a unit of its underlying asset some time in the future, at a price
decided now. If the holder decides to buy the unit of underlying asset, they
will exercise the option. The price they pay is called the exercise price. If the
option is European the holder may exercise the option only on the exercise or
maturity date of the option. American options may be exercised at any time
up to and including the maturity date. An option will be either American
or European, and it will have the fundamental characteristics: underlying
asset, exercise price and maturity date.
1.1.1 An example
In New Zealand, it is possible to buy call options on the shares of Brier-
ley Investments Limited (BIL). These options are traded along with options
on other underlying assets on the New Zealand Futures and Options Ex-
change (NZFOE), information about which can be found on the internet at
http://www.nzfoe.co.nz/. For example, Investor X could purchase a BIL
option traded on the NZFOE, maturing in August 1998, with an exercise
price of $1.20. All share options on the NZFOE are American, and so this
option allows Investor X to buy 1000 BIL shares for $1200 any time between
now and August 1998. If Brierley shares trade above $1.20 between now and
August, Investor X may choose to exercise the option and receive the thou-
sand shares. Alternatively, X might exercise the option and immediately sell
the shares at the current share price (which would be greater then $1.20) for
a prot. If the BIL share price does not exceed $1.20 before August, Investor
X can (and should) let the option lapse, at no further cost.
1.2 The Value of Call Options
Although many traded options are American, and upon exercise yield many
shares, for the remainder of this project I will consider only European call
1.2. THE VALUE OF CALL OPTIONS 3
options, whose underlying asset is a single share.
A call option is a derivative asset, whose value is based on the value of
another asset, namely the underlying stock. Since exercise of the call option
in the future delivers this share, the price of the option will obviously reect
the present worth of this share and the chances of it being higher than the
exercise price on the maturity date.
Let me present the following denitions:
Denition 1.1. Let S
t
be the price at time t of a share paying no dividends
over the time interval [t, T].
Denition 1.2. Let C
t
be the price at time t of a European option.
Denition 1.3. Let K be the exercise price of a European option, payable
on exercise, for a single share with price S
t
at time t.
Denition 1.4. Let T be the maturity date of the European option, and
= T t the time until maturity from time t.
Denition 1.5. Let r be the risk-free rate, which is payable continuously on
an asset whose future value is certain.
Denition 1.6. A European option is in-the-money if the current share
price S
t
exceeds K, at-the-money if the current share price is equal to K,
and out-of-the-money if the current share price is less than K.
On the maturity date T, the European option either expires worthless,
or delivers a single share, with value S
T
, in exchange for a cash payment K.
The payo of the option at maturity can be represented mathematically by
the equation:
Payo = C
T
=

S
T
K S
T
> K
0 S
T
K
(1.1)
or equivalently C
T
= max(0, S
T
K) = (S
T
K)
+
.
4 CHAPTER 1. INTRODUCTION TO OPTIONS
Prior to maturity, at time t, the option will have value not less than zero,
since the option cannot yield a negative payo, and also not less than the
current share price S
t
less the present value of the exercise price discounted
at the risk-free rate Ke
r
. This is established in the following theorem,
whose proof is standard and can be found in Hull (1997).
Theorem 1.1 (Lower Bounds for Call Option Value).
C
t
max(0, S
t
Ke
r
)
Proof. Since the option yields a non-negative payo in the future, the price
paid now for the opportunity to receive those payos must not be less than
zero, Hence C
t
0.
Consider now two portfolios:
Portfolio A, consisting of a single option;
Portfolio B, consisting of a share and a liability of K, payable at T.
At T, the values of portfolios A and B are:
V
A
T
= C
T
= max(0, S
T
K)
V
B
T
= S
T
K
respectively, and so we see V
A
T
V
B
T
, and hence it follows that V
A
t
V
B
t
.
If the latter relationship were not true, arbitrage prots could be earned by
selling portfolio B and investing in portfolio A. Now V
B
t
is given by
V
B
t
= S
t
Ke
r
and hence
C
t
S
t
Ke
r
. (1.2)
1.2. THE VALUE OF CALL OPTIONS 5
Option prices given by any option pricing model should obey the bounds
given in Equation (1.2), and will have the same general appearance as the
function shown in Figure 1.1. Properties of option prices appear in Merton
(1973), and in particular, he proves that call prices must be convex in the
share price
1
.
Share Price
O
p
t
i
o
n

P
r
i
c
e
0
0
Ke
r
Ct
St Ke
r
Figure 1.1: The lower bounds for call option value, and a possible form for
the call price.
From the relationship given in Theorem 1.1 it is immediately apparent
that the option price must depend on at least four factors:
S
t
, the current share price;
, the time to maturity of the option;
K, the exercise price of the option;
and r, the continuously compounding risk-free rate.
1
Merton (1973), Theorem 10, page 150.
6 CHAPTER 1. INTRODUCTION TO OPTIONS
In addition, the option price will depend on the stochastic properties of S
T
.
The fact that the call price is not equal to the lower bound given in Theorem
1.1 is due to the random nature of the future share price S
T
, and in particular:
, the share price volatility.
This parameter, which will be dened more formally later, represents the
uncertainty of future share prices. As this parameter increases, the risk
associated with a future share price increases. The option price may be
thought of as the sum of the lower bound and a premium, where the premium
is monotonically increasing in .
Treating S
t
as xed, and considering each of , K and r in turn, ceteris
paribus, we can anticipate the eect a change in each factor might have on
the current option price, using the lower bound for the option price given in
Theorem 1.1.
As the time to maturity increases, the present value of the exercise
payment at the risk-free rate r diminishes:
lim

Ke
r
= 0,
and so the lower bound C
t
= S
t
Ke
r
in Figure 1.1 is translated to the left
as the y intercept term decreases, and so the option price C
t
corresponding
to any particular S
t
must increase to compensate.
As the exercise payment increases, there is an opposite eect on the lower
bound C
t
= S
t
Ke
r
. In this case the y intercept term will increase,
thus translating the lower bound to the right, and allowing C
t
to decrease.
Increasing the exercise price therefore decreases the value of a European
option.
As the risk-free rate r increases, the present value of the exercise payment
Ke
r
will decrease as it did when was increased, and hence the option
value will increase.
At exercise, the option delivers the payo (S
T
K)
+
. S
T
is of course a
random variable, since at the current time t we do not know for sure what
1.2. THE VALUE OF CALL OPTIONS 7
the share price at T will be. In order to make any statements about the
probabilistic properties of S
T
, assumptions must be made on how the share
price evolves through time.
The evolution of a general process X
t
may be described by the following
stochastic dierential equation (SDE):
dX
t
= (X
t
, t)dt +(X
t
, t)dB
t
(1.3)
where dX
t
may be interpreted as the change in X
t
over the period [t, t +dt],
(X
t
, t) and (X
t
, t) are functions of X
t
and t, and {B
t
} is Brownian motion,
with initial condition B
0
= 0. This process is too general for our purposes,
and I will restrict attention to two specic cases, geometric Brownian motion
(GBM), and Constant Elasticity of Variance (CEV) evolution.
Denition 1.7. A share price that follows geometric Brownian motion (GBM)
is a solution to the following SDE:
dS
t
= S
t
dt +S
t
dB
t
(t > 0)
where and are constant, and B
0
= 0.
Denition 1.8. A share price that follows the Constant Elasticity of Vari-
ance (CEV) model is a solution to the following SDE:
dS
t
= S
t
dt +S

2
t
dB
t
(t > 0) (1.4)
where , and are constant, and B
0
= 0.
It is clear from Denitions 1.7 and 1.8 that GBM is a special case of
the CEV model, and corresponds to the case when = 2. The solution to
Equation (1.4) has very dierent behaviour for the three cases = 2, < 2,
and > 2. In the rst case, the solution to the SDE above is geometric
Brownian motion, which is a well known and widely studied process. This
process, and the price of a call option over a share price following GBM,
8 CHAPTER 1. INTRODUCTION TO OPTIONS
are described in Chapter 2. When < 2, the share price is the original
Constant Elasticity of Variance process, and is considered, again with its
companion option prices, in Chapter 3. The third case, corresponding to
> 2 is mentioned briey at the end of Chapter 3, and is applied in Chapter
4 along with both other cases.
Chapter 2
GBM and the Black-Scholes
Model
9
10 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
2.1 Introduction
Analysis of share prices over time would suggest that they are discrete-time,
discrete-variable processes. This means that they change at discrete time
points, and may take on only discrete values. In practice, however, share
prices are generally modelled using continuous-time, continuous-variable pro-
cesses. The geometric Brownian motion (GBM) process examined in this
chapter, and the Constant Elasticity of Variance (CEV) process considered
in the following chapter are continuous-time, continuous-variable processes.
In addition, both these models are Markovian, meaning that the only rele-
vant information regarding the future of the process is the present value, and
that the past is irrelevant. This can be expressed mathematically as follows:
P(S
t+s
< s|S
u
, 0 u t) = P(S
t+s
< s|S
t
).
This property is consistent with weak form eciency in the share market,
since it implies that all information in prices S
0
, S
1
, . . . , S
t1
is encapsulated
in the present price S
t
.
The Black-Scholes Model was rst presented in an empirical paper by
Black & Scholes (1972), which was quickly followed by its derivation in Black
& Scholes (1973). This model is based on a number of restrictive assump-
tions, one of which is that the price of the underlying asset has a lognormal
distribution at the end of any nite (forward) interval, conditional on its
value at some initial starting point. It will be shown that if we assume that
the share price follows GBM, then this condition will be met. In this chapter
I will deal initially with properties of geometric Brownian motion, and then
examine the Black-Scholes model.
2.2 Share Price Evolution
Derivation of the Black-Scholes option pricing equation requires the assump-
tion that the future share price has a lognormal distribution. This condition
2.2. SHARE PRICE EVOLUTION 11
is met if share price follows GBM, a process which is dened in Denition
1.7, and is a solution to the following SDE:
dS
t
= S
t
dt +S
t
dB
t
(2.1)
with initial condition B
0
= 0, and where S
t
is the share price at time t, is
the continuously compounding expected growth rate of S
t
, is the standard
deviation of the instantaneous return on S
t
, and {B
t
} is Brownian motion,
with E(dB
t
) = 0 and Var(dB
t
) = dt. Note that both and are constants,
independent of time and the current share price, and that Equation (2.1) is a
special case of Equation (1.4), with = 2 and = . I show below that the
solution of the SDE above has a lognormal distribution. To prove this it is
necessary to use a result from stochastic calculus called It os Dierentiation
Lemma.
Result 2.1 (It os Dierentiation Lemma). Suppose that f(x, t) and its
partial derivatives f
x
, f
xx
and f
t
are continuous. If X
t
is given by
dX
t
= (X
t
, t)dt +(X
t
, t)dB
t
then Y
t
= f(X
t
, t) has stochastic dierential:
dY
t
= ((X
t
, t)f
x
+f
t
+
1
2

2
(X
t
, t)f
xx
)dt +(X
t
, t)f
x
dB
t
= f
x
dX
t
+f
t
dt +
1
2

2
(X
t
, t)f
xx
dt.
Hull (1997) gives a sketch proof of this result using a Taylor series ex-
pansion. Using It os Lemma, we can now prove the following well known
theorems.
Theorem 2.1. Conditional on its value at time t, a share price S
T
that
follows GBM will have a lognormal distribution at T > t, with parameters
E(ln S
T
) = ln S
t
+ (
1
2

2
) and Var(ln S
T
) =
2
, where = T t.
Moreover, the form for S
T
given S
t
will be:
S
T
= S
t
e
(
1
2

2
)+

Z
where Z is a standard normal variable with mean zero and unit variance.
12 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
Proof. Consider the transformation Y
t
= ln S
t
. Referring to the SDE (2.1),
and to Result 2.1, we see that:
X
t
= S
t
(X
t
, t) = S
t
(X
t
, t) = S
t
f(X
t
, t) = ln S
t
and so applying It os Lemma
d ln S
t
=
ln S
t
t
dt +
ln S
t
S
t
dS
t
+
1
2
(S
t
)
2

2
ln S
t
S
t
2
dt
= 0 dt +
1
S
t
(S
t
dt +S
t
dB
t
)
1
2

2
S
2
t
1
S
2
t
dt
=


1
2

dt +dB
t
(2.2)
Thus, integrating both sides from t to T yields:
ln S
T
ln S
t
=


1
2

(T t) +

T
t
dB
t
=


1
2

+(B
T
B
t
)
From the properties of Brownian motion, in particular its independent incre-
ments:
B
T
B
t
B
Tt
B
0
= B

since B
0
= 0, and where denotes is distributed as. Hence:
ln S
T
ln S
t
+


1
2

+B

. (2.3)
Conditioned on S
t
, it is clear that the only random variable in the RHS
of the above equation is the Brownian motion term B

. Using the fact that


B
t
N(0, t) for any t > 0, we obtain the mean and variance of ln S
T
given
S
t
:
E(ln S
T
|S
t
) = E(ln S
t
+


1
2

+B

|S
t
)
= ln S
t
+


1
2

+E(B

)
= ln S
t
+


1
2

2.2. SHARE PRICE EVOLUTION 13


Var(ln S
T
|S
t
) = Var(ln S
t
+


1
2

+B

|S
t
)
=
2
Var(B

)
=
2

In addition, if X is a normal random variable, then the linear combination


a + bX, where a and b are both constant, is also normal with mean aE(X)
and variance b
2
Var(X). Combining this with the mean and variance above
it is clear that
ln S
T
|S
t
N

ln S
t
+


1
2

,
2

(2.4)
i.e. S
T
is lognormal with parameters ln S
t
+


1
2

and
2
. Moreover,
since Z =
B

N(0, 1), it follows directly from Equation (2.3) that


S
T
= S
t
e
(
1
2

2
)+

Z
(2.5)
as required.
Theorem 2.2 (Moments of a Share Price following GBM). The mean
and variance of the share price S
T
conditional on an earlier share price S
t
,
0 t < T are S
t
e

and S
2
t
e
2
(e

1) respectively.
Proof. Note rst that the moment generating function of an N(0, 1) variable
is E(e
sZ
) = e
1
2
s
2
. This can be used to nd the moments of the random
variable of interest S
T
|S
t
.
E(S
T
|S
t
) = E

S
t
e
(
1
2

2
)+

S
t

= S
t
e
(
1
2

2
)
E

= S
t
e
(
1
2

2
)
e
1
2

= S
t
e

(2.6)
E(S
2
T
|S
t
) = E

S
2
t
e
2(
1
2

2
)+2

S
t

= S
2
t
e
2(
1
2

2
)
E

e
2

= S
2
t
e
2(
1
2

2
)
e
2
2

= S
2
t
e
(2+
2
)
14 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
Forming the variance using the relationship Var(X) = E(X
2
) E(X)
2
, we
obtain
Var(S
T
|S
t
) = S
2
t
e
2
(e

2
1) (2.7)
as required.
Note that if share price evolution is a deterministic process, i.e. = 0,
then S
T
equals the mean of the stochastic process: S
t
e

. Thus using either


the expected value, or the deterministic case, the parameter can be thought
of as the continuously compounding expected rate of return on the share per
unit time, and may be modelled for a particular stock using the Capital Asset
Pricing Model (CAPM), which features both a market risk premium, and a
measure of the riskiness of the particular rm compared to the market.
The CAPM describes the expected return on a particular asset:

j
= r + MRP
Cov(R
j
, R
m
)

2
m
where MRP is the market risk premium, R
j
is the return on asset j,
j
is
the expected value of that return, R
m
is the return on the market portfolio,
and
2
m
is the variance of the market return. Aggregate investor attitudes
towards risk aect the size of the market risk premium, which has a direct
eect on the size of
j
. The size of this eect is determined by the measure
of systematic risk:
Cov(R
j
, R
m
)

2
m
which compares the risk associated with the particular asset to the risk as-
sociated with the market as a whole.
The parameter is the only component of the GBM model that reects
investor risk attitudes. The return on an asset j can be modelled using the
standard univariate linear regression model:
R
j
=
j
+b
j
R
m
+
j
2.2. SHARE PRICE EVOLUTION 15
where R
j
and R
m
are as above,
j
and b
j
are the regression model parameters,
and
j
is a stochastic error term, with variance
2

j
. Applying the variance
operator to all terms in the equation above yields the relationship:

2
j
= b
2
j

2
m
+
2

j
.
The variance of the market return,
2
m
measures the systematic risk in the
system, whereas
2

j
measures the non-systematic risk. Hence the parameter
reects a combination of these, but not investor risk attitudes.
2.2.1 Simulation of Geometric Brownian Motion
Simulation of GBM series, or prices at a particular time in the future is
a useful way of analysing the properties of GBM, and later, analysing the
properties of Black-Scholes option prices. Because the solution to the SDE
(2.1) is known, there is no need to use a numerical method to approximate
the solution, but rather the solution can be simulated directly.
The solution to the SDE was given in Equation (2.5) and is:
S
T
= S
t
e
(
1
2

2
)+

Z
where Z N(0, 1). Hence in order to simulate a single price at T, a single
realisation of Z can be obtained, and the share price computed directly.
In order to simulate an entire GBM series, we can divide the interval of
interest [t, T] into n subintervals dened by the times:
t = t
0
< t
1
< < t
i
< < t
n1
< t
n
= T
where the intervals are not necessarily of equal length. Equation (2.5) can
also be written to give the share price at time t
i
conditional on the share
price at t
i1
:
S
t
i
= S
t
i1
e
(
1
2

2
)(t
i
t
i1
)+

t
i
t
i1
Z
16 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
hence simulating n realisations of Z, the series can be constructed as follows:
S
t
i
= S
t
i

j=1
S
t
j
S
t
j1
= S
t
i

j=1
e
(
1
2

2
)(t
j
t
j1
)+

t
j
t
j1
Z
j
= S
t
exp

j=1
(
1
2

2
)(t
j
t
j1
) +

t
j
t
j1
Z
j

= S
t
e
(
1
2

2
)(t
i
t)
exp

j=1

t
j
t
j1
Z
j

. (2.8)
A program which simulates GBM using Equation (2.8) is given in Appendix
D.1.
Time - years
S
h
a
r
e

P
r
i
c
e
0.0 0.2 0.4 0.6 0.8 1.0
4
.
5
5
.
0
5
.
5
6
.
0
Figure 2.1: A realisation of GBM with initial value S
t
= $5, and parameters
= 0.1, = 0.3 and 250 subintervals.
Figure 2.1 shows a single realisation of geometric Brownian motion with
S
t
= $5, = 1 year, = 0.1 and = 0.3. This particular realisation has
2.2. SHARE PRICE EVOLUTION 17
S
T
= $5.12, which is smaller than its expected value E(S
T
|S
t
) = $5e
0.1
=
$5.53 but well within a single standard deviation s(S
T
|S
t
) = S
t
e

2
1 =
$1.696 of it.
The daily returns for the series {S
t
} are dened as:
R
t
= ln S
t+t
ln S
t
where t =
1
250
years is approximately one trading day. Whilst the series
{S
t
} is clearly not a stationary process, Equation (2.2) indicates that the
daily returns should be stationary, with a mean (
1
2

2
)t and variance

2
t. A plot of the daily returns can be seen in Figure 2.2, with an estimate
of the mean level and standard deviation shown
1
. These have been estimated
using a Lowess lter with a smoothing window of 30 observations. The
Lowess lter is a robust, centred moving average lter, and was derived by
Cleveland (1979). This lter was designed to smooth scatterplots, but has
application to the equi-spaced observations of a time series. It estimates the
average value at t
i
using weights from the bisquare function:
B(x) =

(1 x
2
)
2
|x| < 1
0 |x| 1
where x depends on the time t
i
and the smoothing window, and by making
adjustments for outlying values. In this case I have used a smoothing window
of 30 days, so that values outside this window are given zero weight, and
hence do not aect the estimate. The estimates produced at the ends of the
series are unreliable due to back- and forecasting of share price values. These
estimates, obtained using estimated share price data, are not shown in the
graph.
Also shown in Figure 2.2 is the true mean for the daily returns of (
1
2

2
)t which is negligible for the parameters chosen
2
. We see that the es-
timated mean does indeed oscillate about the actual mean level, and that
1
The series actually shown are the estimated mean, and the estimated mean two
estimated standard deviations, from which the estimated standard deviation itself can be
recovered.
2
Nevertheless, over a year it compounds to a signicant amount.
18 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
Time - years
L
o
g
-
r
e
t
u
r
n
s
0.0 0.2 0.4 0.6 0.8 1.0
-
0
.
0
4
-
0
.
0
2
0
.
0
0
.
0
2
0
.
0
4
0
.
0
6
Figure 2.2: The daily returns for the series shown in Figure 2.1 with estimated
and actual mean, and the estimated mean 2 standard deviation limits.
the estimated standard deviation appears approximately constant. In fact,
an autocorrelation plot for the daily return series shows no signicant au-
tocorrelation for non-zero lags. This is not surprising, since the series was
generated in the rst place using realisations of the standard normal variable
that should indeed be independent of one another, and hence uncorrelated.
2.2.2 The Future Share Price S
T
As discussed in Chapter 1, the value of a European option at t will certainly
depend on the share price at the future exercise time T. Since we are able to
simulate geometric Brownian motion, we can also simulate the distribution
of future share prices by generating many realisations of the same process.
The value of this is largely illustrative, since many of the properties of GBM
are well known. Suppose a particular share price truly follows GBM, with
known and , then N realisations of the share price at T can be obtained
2.2. SHARE PRICE EVOLUTION 19
using the second program seen in Appendix D.1. Simulation of the quantity
S
T
is a useful way of deciding what properties the share price will have at T,
and hence what payo (if any) the option is likely to deliver.
In the case of GBM, the theoretical distribution is known, and in this
case can be compared to the results of the simulation to appraise the sim-
ulation procedure, and help guide the eye. Figure 2.3 shows the result of
a simulation of 5000 share prices = 1 year in the future, with additional
parameters S
t
= $5, = 0.1 and = 0.3. The nal value of the time series
in Figure 2.1 has the same properties as each of the observations shown in
the histogram. Superimposed on the observed distribution is the theoretical
lognormal density curve with parameters E(ln S
T
|S
t
) = ln 5 + (0.1 +
1
2
0.3
2
)
and Var(ln S
T
|S
t
) = 0.3
2
. It is clear from the graph that the t is very good,
particularly when the bars are small. This is expected since the height of fre-
quency histogram bars is a Poisson random variable with mean and variance
equal to the expected height of the bars. Hence, the smaller bars heights
will have a small standard deviation and should be closer to the curve than
the higher bars. The heights of the equi-width bars in the relative frequency
histogram shown in Figure 2.3 are proportional to the Poisson heights in a
frequency histogram, and so the variability comments hold.
A useful means of gauging the success of the simulation procedure is to
estimate the mean and variance of a sample of share prices, and compare
these to the theoretical values given by Equations (2.6) and (2.7) respec-
tively. These estimates are given by the sample mean and sample variance
of 5.5397 and 2.8756 respectively, compared to theoretical values of 5.5259
and 2.8756. Note that while the means dier slightly, the variance estimate
is accurate to within 4 decimal places, again testimony to the accuracy with
which GBM can be simulated. Note that these estimates do not correspond
to the parameters of the lognormal distribution, which are the mean and
variance of the log share prices. The maximum likelihood method could be
used to t the best lognormal distribution to the sample values but this
has not been done here.
20 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
2 4 6 8 10 12 14
0
.
0
0
.
0
5
0
.
1
0
0
.
1
5
0
.
2
0
0
.
2
5
Share Price
R
e
l
a
t
i
v
e

F
r
e
q
u
e
n
c
y
Figure 2.3: 5000 realisations of S
T
, a future geometric Brownian motion
price, with initial value S
t
= $5, and parameters = 1, = 0.1 and = 0.3,
and the theoretical lognormal distribution for S
T
.
2.3 Properties of C
T
- the Exercise Payo
The properties of the call value at maturity are intimately linked to those of
the share price by the equation:
C
T
= max(S
T
K, 0)
= (S
T
K)
+
(2.9)
where K is the exercise price of the call option. It is this payo that investors
are interested in valuing. Such a future cash ow could be valued using the
equation
P
t
= e

E(C
T
|S
t
) (2.10)
where P
t
would be the price paid now for the payo C
T
, which would be
received at time T. This equation features two rates particular to the risk
2.3. PROPERTIES OF C
T
- THE EXERCISE PAYOFF 21
preferences of investors in aggregate: , the continuously compounded ex-
pected rate of return which features in the expectation, and , the discount
rate for future cash ows. It will be shown later that both and can be
treated as if they were the risk-free rate r, for valuing this particular future
cash ow.
Consider the simple transformation Y
T
= S
T
K. It is clear Y
T
has mean
E(S
T
)K, variance Var(S
T
), and Y
T
+K has a lognormal distribution. Note
that Y
T
itself does not have a lognormal distribution, since the lognormal
distribution is dened on the range [0, ) whereas Y
T
is dened on [K, ).
However, the shape of the distribution of Y
T
will be identical to that of S
T
,
since we have the relationship
P(Y
T
< y) = P(S
T
K < y) = P(S
T
< y +K).
Next consider C
T
= Y
+
T
= max(0, Y
T
). It is clear that P(C
T
= 0) =
P(S
T
K) and so C
T
will not have a continuous distribution function.
Theorem 2.3 (Distribution of C
T
given S
t
). Given S
t
, C
T
= (S
T
K)
+
has a mixed distribution
P(C
T
c|S
t
) =

0 c < 0
F
S
T
|S
t
(K +c, ) c 0
with density:
f
C
T
|S
t
(c, ) = F
S
T
|S
t
(K, ) (c) +

0 c < 0
f
S
T
|S
t
(K +c, ) c > 0
where F
S
T
|S
t
and f
S
T
|S
t
are the cumulative distribution and density functions
for the share price S
T
, and (c) is the Dirac delta function.
Proof. Since S
T
given S
t
has a lognormal distribution with parameters ln S
t
+
(
1
2

2
) and
2
, given S
t
:
P(S
T
K c|S
t
) = P(S
T
K +c|S
t
)
= P(ln S
T
ln(K +c)|S
t
)
=

ln(K +c) ln S
t
(
1
2

2
)

22 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL


where (x) =

(z)dz is the standard normal cumulative distribution


function, and (z) is the standard normal probability density function. Thus:
F
C
T
|S
t
(c, ) = P(C
T
c|S
t
)
=

0 c < 0
P(S
T
K c|S
t
) c 0
=

0 c < 0

ln(K+c)lnS
t
(
1
2

2
)

c 0
(2.11)
f
C
T
|S
t
(c, ) =

0 c < 0
P(C
T
= 0|S
t
) (c) c = 0

ln(K+c)lnS
t
(
1
2

2
)

c > 0
=

0 c < 0
P(S
T
K|S
t
) (c) c = 0
1
(K+c)

ln(K+c)lnS
t
(
1
2

2
)

c > 0
=

0 c < 0
F
S
T
|S
t
(K, ) (c) c = 0
f
S
T
|S
t
(K +c, ) c > 0
(2.12)
where F
S
T
|S
t
and f
S
T
|S
t
are the cumulative distribution and density functions
for the terminal share price S
T
given by:
F
S
T
|S
t
(s, ) = P(S
T
< s|S
t
)
=

ln s ln S
t
(
1
2

2
)

(2.13)
f
S
T
|S
t
(s, ) =
F
S
T
|S
t
(s, )
s
=
1
s

ln s ln S
t
(
1
2

2
)

(2.14)
and (c) is the Dirac delta function dened by:

(c)dc =

0 x < 0
1 x 0.
2.3. PROPERTIES OF C
T
- THE EXERCISE PAYOFF 23
2.3.1 Mean and Variance of C
T
given S
t
The mean and variance of C
T
given S
t
can be found using the density function
for C
T
given in Equation (2.12). An equivalent but simpler method is to note
that C
T
= h(Z), where Z is a standard normal random variable. Then the
expected value of any function, g, of C
T
can be found using the relationship
E{(g h)(Z)} =

(g h)(z)(z)dz
where g h is the composition of g with h. This yields the following.
Theorem 2.4 (Moments of C
T
). Given S
t
, C
T
= (S
T
K)
+
has mean
E(C
T
|S
t
) = S
t
e

(g
t
) K(g
t

)
and mean square
E(C
2
T
|S
t
) = S
2
t
e
(2+
2
)
(g
t
+

) 2S
t
e

K(g
t
) +K
2
(g
t

)
where
g
t
=
ln S
t
ln K + ( +
1
2

2
)

Proof. Note rstly that from Equation (2.5), it is clear that S


T
is a function
of a standard normal variable Z. Hence, we nd that C
T
too is a function of
Z.
C
T
= (S
T
K)
+
=

0 S
T
K
S
t
e
(
1
2

2
)+

Z
K S
T
> K
Note that S
T
K implies
Z
ln S
t
+ ln K (
1
2

2
)

= g
t
+

24 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL


and therefore the rst moment can be determined thus:
E(C
T
|S
t
) =


g
t
+

S
t
e
(
1
2

2
)+

z
K

(z)dz
= S
t
e


g
t
+

1
2
(z

)
2

2
dz K


g
t
+

(z)dz
= S
t
e


g
t
(y)dy K(g
t

)
= S
t
e

(g
t
) K(g
t

).
The second moment gives us a means of calculating the variance of C
T
given
S
t
, and is found as follows:
E(C
2
T
|S
t
) =


g
t
+

S
t
e
(
1
2

2
)+

z
K

2
(z)dz
= S
2
t
e
(2+
2
)


g
t
+

1
2
(z2

)
2

2
dz 2S
t
e

K(g
t
) +K
2
(g
t

)
= S
2
t
e
(2+
2
)


g
t

(y)dy 2S
t
e

K(g
t
) +K
2
(g
t

)
= S
2
t
e
(2+
2
)
(g
t
+

) 2S
t
e

K(g
t
) +K
2
(g
t

).
The variance can be formed as usual using Var(C
T
|S
t
) = E(C
2
T
|S
t
)E(C
T
|S
t
)
2
.
Thus, from Equation (2.10), an investor may value the option using the
expected value, and the market rates and , to give a price at t:
P
t
= S
t
e
()
(g
t
) Ke

(g
t

). (2.15)
where g
t
is dened in Theorem 2.4 above.
Note that as aggregate investor risk attitudes change, both and will
change, and hence it appears that P
t
will change. However, there is theory
to show that the true value of C
t
should be independent of risk premia on
assets, thus any change in is oset by an appropriate change in when the
fair option price is calculated.
2.4. THE BLACK-SCHOLES FORMULA 25
2.3.2 Simulation of C
T
A sample of terminal call values C
T
can be obtained from a sample of share
prices using the simple relationship (2.9). The distribution of such a sample
can easily be recovered from the density function of S
T
shown in Figure 2.3
by repositioning the origin at K, and setting all observations less than K to
zero.
As before, in the case of C
T
there is also good agreement between the
theoretical and observed mean and variance. For an exercise price of K = $5,
the sample yields respective values of 0.9309 and 1.7714 for the estimated
mean and variance, compared to theoretical values of 0.9247 and 1.7497.
It is also interesting to note the relative frequency of the event C
T
= 0,
i.e. the proportion of occasions on which the option would not be exercised.
The theoretical probability that the value of C
T
will be zero is given by the
equation
P(C
T
= 0|S
t
) = P(S
T
< K|S
t
) = (g
t
+

)
which for the simulation equals 0.4273. Hence, for this particular simulation,
the expected number of options that are not exercised is 2136. This can be
compared to the sample estimate of 2109.
2.4 The Black-Scholes Formula
Black and Scholes rst presented the Black-Scholes model in an empirical
paper (Black & Scholes 1972) with the theoretical underpinnings following
in Black & Scholes (1973). Their model considers pricing a European call
option, over a stock traded in a market with the following properties:
the instantaneous interest rate is known, and constant;
the share price follows geometric Brownian motion, from which it fol-
lows directly:
26 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
the variance rate
2
of the return on the stock is constant, and
known;
no dividends are paid on the share over the life of the option;
there are no transaction costs, dierential taxes, or short-selling restric-
tions, and it is possible to trade any fraction of the stock or option.
Under these conditions Black & Scholes were able to obtain a price for the
option that depends only on the current share price, the time to maturity,
and on constants K, r, and that are assumed known.
The partial dierential equation (PDE) for the price of a call over a
slightly more general share price process than GBM is established in the
following well known theorem.
Theorem 2.5 (The Call Price PDE). Suppose S
t
is the solution to the
SDE:
dS
t
= (S
t
, t)S
t
dt +(S
t
, t)S
t
dB
t
(2.16)
then the price at time t of a call option over a share with price S
t
must satisfy
the PDE:
1
2

2
(S
t
, t)S
2
t

2
C
S
2
+rS
t
C
S
+
C
t
rC
t
= 0.
subject to the boundary condition
C
T
= (S
T
K)
+
where r is the continuously compounding risk-free rate.
Proof. Consider forming a self-nancing portfolio at t, of a
t
units of the stock
with value S
t
, and b
t
units of the call option with value C
t
, where a
t
and b
t
may be functions of both share price at t and time. This portfolio has value
at t:
V
t
= a
t
S
t
+b
t
C
t
2.4. THE BLACK-SCHOLES FORMULA 27
and over the period [t, t +dt] the change in portfolio value will be:
dV
t
= V
t+dt
V
t
= a
t+dt
S
t+dt
+b
t+dt
C
t+dt
a
t
S
t
b
t
C
t
= (a
t+dt
a
t
)S
t+dt
+a
t
dS
t
+ (b
t+dt
b
t
)C
t+dt
+b
t
dC
t
= a
t
dS
t
+b
t
dC
t
.
The nal step is justied by the assumption that the portfolio is self nancing.
This means that any change in the quantity of stock held is nanced by a
change in the quantity of the option held, and vice versa. This yields
da
t
S
t+dt
+db
t
C
t+dt
= 0
as required.
The form for dS
t
is given by Equation (2.16), and dC
t
can be obtained
from it using It os Lemma. The option price can be considered a function of
two variables: the current share price and time. Hence we can write
C
t
= C(S
t
, t)
where S
t
is a solution to the familiar SDE
dS
t
= (S
t
, t)S
t
dt +(S
t
, t)S
t
dB
t
.
Referring to Result 2.1, we see that
X
t
= S
t
(X
t
, t) = (S
t
, t)S
t
(X
t
, t) = (S
t
, t)S
t
f(X
t
, t) = C(S
t
, t).
Hence, applying It os Lemma we can determine the change in C
t
over the
period [t, t +dt]:
dC
t
=
C
t
dt +
C
S
dS
t
+
1
2
((S
t
, t)S
t
)
2

2
C
S
2
dt.
28 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
The change in portfolio value over the interval [t, t +dt] thus becomes:
dV
t
= a
t
dS
t
+b
t
dC
t
= a
t
dS
t
+b
t

C
t
dt +
C
S
dS
t
+
1
2

2
(S
t
, t)S
2
t

2
C
S
2
dt

a
t
+b
t
C
S

dS
t
+b
t

C
t
+
1
2

2
(S
t
, t)S
2
t

2
C
S
2

dt
and the portfolios rate of return:
dV
t
V
t
=
a
t
dS
t
+b
t
dC
t
a
t
S
t
+b
t
C
t
=

a
t
+b
t
C
S

dS
t
+b
t

C
t
+
1
2

2
(S
t
, t)S
2
t

2
C
S
2

dt
a
t
S
t
+b
t
C
t
=

f
t
+
C
S

dS
t
+

C
t
+
1
2

2
(S
t
, t)S
2
t

2
C
S
2

dt
f
t
S
t
+C
t
where f
t
= a
t
/b
t
.
Since the only stochastic elements are present in the dS
t
term, these can
be eliminated by choice of f
t
to form a portfolio whose change in value over
the period [t, t + dt] is deterministic. Setting the coecient of dS
t
to zero
gives
f
t
=
C
S
and so Var(
dV
t
V
t
) = 0 and the rate of return on the portfolio becomes:
dV
t
V
t
=

C
t
+
1
2

2
(S
t
, t)S
2
t

2
C
S
2

dt

C
S
S
t
+C
t
. (2.17)
By this choice of f
t
, the number of units of stock held per unit of option held,
the portfolio has no risk over [t, t +dt], and so by arbitrage theory its rate of
return should be the risk free rate r, giving
dV
t
= rV
t
dt or dV
t
rV
t
dt = 0.
If this were not the case, investors could borrow (lend) at the risk-free rate
r, and go long (short) in the portfolio of stock and option and earn arbitrage
2.4. THE BLACK-SCHOLES FORMULA 29
prots. Substituting terms for dV
t
and V
t
in the above expression, yields the
desired PDE:

C
t
+
1
2

2
(S
t
, t)S
2
t

2
C
S
2

dt r

C
S
S
t
+C
t

dt = 0
1
2

2
(S
t
, t)S
2
t

2
C
S
2
+rS
t
C
S
+
C
t
rC
t
= 0. (2.18)
The solution C
t
must also satisfy the boundary condition
C
T
= (S
T
K)
+
since at T, the option yields the payo C
T
.
Theorem 2.6 (The Black-Scholes PDE). The price of a European call
option, C
t
, over a share whose price follows GBM, with time until maturity,
must satisfy the partial dierential equation (PDE):
1
2

2
C
S
2
+rS
C
S
+
C
t
rC
t
= 0 (2.19)
subject to the boundary condition
C
T
= (S
T
K)
+
where r is the continuously compounding risk-free rate.
Proof. The Black-Scholes PDE follows from Theorem 2.5, with
(S
t
, t) =
as does the boundary condition.
It is signicant that neither of the PDEs (2.19) nor (2.18) feature ,
the only component of the respective models that describes investor risk
preferences. Cox & Ross (1976) use this fact to solve this and other PDEs
using a technique called risk-neutral valuation. Cox & Ross suggest that
since the PDE does not feature risk preferences, then solution of the PDE
30 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
can be achieved by assuming any convenient scenario for investor preferences.
In particular, assuming that investors are risk-neutral provides an alternative
method of deriving solutions like the Black-Scholes, and Constant Elasticity
of Variance formulae, since both and in the Equation (2.10) can be set
to r, and the price P
t
evaluated. The general validity of this approach was
established by Harrison & Kreps (1979).
The following theorem was rst given by Black & Scholes (1972).
Theorem 2.7 (The Black-Scholes Formula). The solution to Equation
(2.19), subject to the boundary condition C
T
= (S
T
K)
+
is given by the
Black-Scholes Formula:
C
t
= S
t
(h
t
) Ke
r
(h
t

)
where
h
t
=
ln S
t
ln K + (r +
1
2

2
)

Proof. Evaluation of the partial derivatives


C
S
,
C
t
and

2
C
S
2
, where
C
t
= S
t
(h
t
) Ke
r
(h
t

) (2.20)
and substitution into the PDE indeed shows that the Black-Scholes formula
is a solution. It is useful to note the relationship:
S
t
(h
t
) Ke
r
(h
t

) = 0.
From this it follows that the partial derivatives are:
C
S
= (h
t
)

2
C
S
2
=
(h
t
)
S
t

and
C
t
=
S
t
(h
t
)
2

rKe
r
(h
t

).
Substituting these derivatives into the PDE (2.19) shows that C
t
as given by
the Black-Scholes formula is indeed a solution of the PDE. Moreover, C
t
also
satises the boundary condition, since setting t = T gives C
T
= (S
T
K)
+
as required.
2.4. THE BLACK-SCHOLES FORMULA 31
Result 2.2. Let the share price S
t
be the solution to the SDE:
dS
t
= S
t
dt +
t
S
t
dB
t
where
t
is a deterministic function of time. Then the price of a call option
on a stock with share price S
t
must satisfy the PDE:
1
2

2
t
S
2
t

2

C
S
2
+rS
t


C
S
+


C
t
r

C
t
= 0
with boundary condition

C
T
= (S
t
K)
+
, and the call price is given by the
Black-Scholes equation, with the substitution:

2
=
2

T
t

2
u
du.
Proof. The proof of this result is given in Appendix B.1.
Equation (2.15) gives the present value at time t, of the expected value of
C
T
, and features two rates and , which depend on investor risk attitudes.
Cox & Ross (1976) evaluate P
t
with both and replaced by r giving a
price which is identical to the Black-Scholes price. This method of valuing
options is called the risk-neutral valuation method, and prices are given by:
C
t
= e
r
E

(C
T
|S
t
)
where E

is the expectation operator taken in a risk-neutral world (so that


= = r). This is appropriate because the PDE of interest does not contain
any parameters which reect risk attitudes.
Note that Result 2.2 has interesting implications for the interpretation of
the volatility parameter used in the Black-Scholes formula. Whilst
2
is
dened as the instantaneous variance of the rate of return on the share price,
it can be treated as if it is the average variance over the remaining life of the
option, since the same pricing formula results. This framework gives a more
intuitive meaning to the parameter .
32 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
2.4.1 Properties of Call Price Prior to Maturity
Prior to maturity, the call price C
t
and the share price S
t
are linked by
the Black-Scholes formula. This link can be used to derive the probability
distribution of the option price at time t +s, where t < t +s < T.
At maturity of the option, the relationship between the share and option
prices was relatively simple:
C
T
= (S
T
K)
+
and yielded a distribution for C
T
that was very similar to that of S
T
. If
t < T, then the relationship between share and option price becomes the
Black-Scholes formula:
C
t
= S
t
(h
t
) Ke
r
(h
t

)
which yields a more complicated probability function for an option price at
a time in the future, but prior to maturity.
Theorem 2.8 (Distribution of Black-Scholes Prices). C
t+s
conditional
on S
t
with s (0, ), is given by the Black-Scholes formula, and has proba-
bility density function:
f
C
t+s
|S
t
(c, ) =

0 c 0
1
BS
1
S
(c;t+s)

s(h

t+s
)

ln BS
1
S
(c;t+s)lnS
t
(
1
2

2
)s

c > 0
where BS
1
S
(c; t +s) is the inverse of the Black-Scholes function with respect
to S at time t +s, evaluated at c, and
h

t+s
=
ln BS
1
S
(c; t +s) ln K + (r +
1
2

2
)( s)

s
Proof. First note that C
t+s
> 0, since the probability of a positive payout is
always greater than zero. Therefore for c < 0, P(C
t+s
< c) = 0. Denoting
2.4. THE BLACK-SCHOLES FORMULA 33
temporarily the Black-Scholes price C
t+s
= BS(S
t+s
) where BS is the Black-
Scholes formula with single argument S
t
, consider now the case c > 0:
F
C
t+s
|S
t
(c, ) = P(C
t+s
< c|S
t
)
= P(BS(S
t+s
) < c|S
t
)
= P(S
t+s
< BS
1
S
(c; t +s)|S
t
)
= P(ln S
t+s
< ln BS
1
S
(c; t +s)|S
t
)
=

ln BS
1
S
(c; t +s) ln S
t
(
1
2

2
)s

since ln S
t+s
N(ln S
t
+(
1
2

2
)s,
2
s). This distribution function features
the inverse of the Black-Scholes function with respect to S
t+s
. Whilst the
form for this inverse cannot be written directly, the Black-Scholes model is a
monotonic increasing function of S
t
, and so computation of the single inverse
value can be achieved using a numerical method such as the Newton-Raphson
algorithm. This method is particularly useful here since the rst derivative
of the inverse with respect to c does have an explicit form which is easily
evaluated. Dierentiating this cumulative distribution function on the range
c > 0 gives the form for the density function on the same range. Noting
that if y = BS
1
S
(c; t + s), then
y
c
can be found by using the chain rule for
dierentiation:
c = BS(y)
1 =
BS(y)
y
y
c
y
c
=
1

ln yln K+(r+
1
2

2
)(s)

since
C
S
= (h
t
). So, noting
BS
1
S
(c; t +s)
c
=
1

ln BS
1
S
(c;t+s)lnK+(r+
1
2

2
)(s)

s
=
1
(h

t+s
)
34 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
the derivative of F
C
t+s
|S
t
(c, ) with respect to c, with c > 0 is:
f
C
t+s
|S
t
(c, ) =

c
F
C
t+s
|S
t
(c)
=
1
BS
1
S
(c; t +s)

ln BS
1
S
(c; t +s) ln S
t
(
1
2

2
)s

1
(h

t+s
)
=
1
BS
1
S
(c; t +s)

s(h

t+s
)

ln BS
1
S
(c; t +s) ln S
t
(
1
2

2
)s

giving nally the density function for C


t+s
:
f
C
t+s
|S
t
(c, ) =

0 c 0
1
BS
1
S
(c;t+s)

s(h

t+s
)

lnBS
1
S
(c;t+s)ln S
t
(
1
2

2
)s

c > 0
(2.21)
Note that in order to evaluate this density function, the Black-Scholes
function must be inverted with respect to S
t
. This cannot be done analyti-
cally and the equation
c = BS(S)
must be solved for S numerically. This can be done using a numerical method
such as the Newton-Raphson method. Details of this method, and its imple-
mentation in this case can be found in Appendix D.2.
2.4.2 Best Predictor of a Future Black-Scholes Price
Although the moments of the theoretical distribution look impossible to de-
rive using the density function above, it is possible to derive the mean price
at a time t + s where 0 < s < . It is known that the best predictor of this
future price, in a mean square sense, is given by the expected value, condi-
tional on the past and present values of the series. In order to calculate the
expected value of C
T
, the fact that S
T
given S
t
is a function of a standard
normal random variable Z was utilised. The same procedure can be used
here.
2.4. THE BLACK-SCHOLES FORMULA 35
Theorem 2.9. The expected value of C
t+s
, given S
t
, where s (0, ), is
given by the equation:
E(C
t+s
|S
t
) = S
t
e
s

h
t
+
(r)s

Ke
r(s)

h
t

+
(r)s

where h
t
is as in the Black-Scholes formula, and is given in Theorem 2.7.
Proof. The form of S
t+s
, where 0 < s < , is given by Equation (2.5)
S
t+s
= S
t
e
(
1
2

2
)s+

sZ
.
Moreover C
t+s
is given by the Black-Scholes formula (2.20) and so:
E(C
t+s
|S
t
) = E(S
t+s
(h
t+s
)|S
t
) Ke
r
E((h
t+s

s)|S
t
) (2.22)
with h
t+s
a function of the random variable S
t+s
.
Noting then that the Black-Scholes price C
t+s
is a function of S
t+s
which
is in turn a function of Z, we conclude that C
t+s
is itself a function of Z
and its expected value can be computed using the standard normal density
function (z) rather than the very complicated f
C
t+s
|S
t
(c, ). I will evaluate
the two expectations in the above equation separately.
The rst expectation of interest is
E(S
t+s
(h
t+s
)|S
t
) =


z=
S
t+s
(h
t+s
)(z)dz
and can be written as two separate components, which I will simplify inde-
pendently:
S
t+s
(z) = S
t
e
(
1
2

2
)s+

sz
1

2
e

1
2
z
2
= S
t
e
s
1

2
e

1
2
(z+

s)
2
= S
t
e
s
(y)
where y = z+

s. Simplifying rst ln S
t+s
, using the same transformation:
ln S
t+s
= ln S
t
+ (
1
2

2
)s +

sz
= ln S
t
+ ( +
1
2

2
)s

sy
36 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
thus h
t+s
becomes:
h
t+s
=
ln S
t+s
ln K + (r +
1
2

2
)( s)

s
=
ln S
t
+ ( +
1
2

2
)s

sy ln K + (r +
1
2

2
)( s)

s
=

ln S
t
ln K + (r +
1
2

2
)

+
( r)s

h
t
+
( r)s

Substituting these expressions into the rst expectation on the right hand
side of Equation (2.22), and making the change of variables z = y +

s
yields:
E(S
t+s
(h
t+s
)|S
t
) =


y=
S
t
e
s
(y)

h
t
+
(r)s

dy
= S
t
e
s

, h
t
+
(r)s

where

2
(x, y; ) =

(z)

y z

1
2

dz
is the cumulative distribution function for a bivariate normal random variable
with zero means, unit variances, and correlation coecient . This distribu-
tion function is symmetric about x and y, and so the order of integration can
be changed to give an alternative distribution function:

2
(x, y; ) =

(z)

x z

1
2

dz.
and in particular

2
(, y; ) =

(z)()dz = (y)
since () = 1. This leads to the simplication of the rst expectation:
E(S
t+s
(h
t+s
)|S
t
) = S
t
e
s

h
t
+
( r)s

.
2.4. THE BLACK-SCHOLES FORMULA 37
Now consider the second expectation in Equation (2.22). I will again
simplify the component of the expression separately, but without making the
y transformation as done in the previous term:
h
t+s

s =
ln S
t+s
ln K + (r
1
2

2
)( s)

s
=
ln S
t
+ (
1
2

2
)s +

sz ln K + (r
1
2

2
)( s)

s
=

ln S
t
ln K + (r
1
2

2
)

+
( r)s

+z

h
t

+
( r)s

+z

Substituting this into the expectation and interchanging the order of inte-
gration as above gives:
E((h
t+s

s|S
t
) =


z=
(z)

h
t

+
(r)s

+z

dz
=
2

, h
t

+
(r)s

h
t

+
(r)s

.
Hence substituting the two expectations into Equation (2.22), we obtain the
expected value of C
t+s
:
E(C
t+s
|S
t
) = S
t
e
s

h
t
+
(r)s

Ke
r(s)

h
t

+
(r)s

(2.23)
as required.
This formula is intriguing, since it is so similar to the Black-Scholes formula
itself, but with the rst S
t+s
replaced by E(S
t+s
|S
t
), and the correction term
in the terms.
2.4.3 Graphical Examination of C
t
Just as the series {S
t
} can be simulated, so too can the series {C
t
}. This
is done using a share price time series and the Black-Scholes formula. In
38 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
addition to parameters selected for simulation of share price evolution, S
t
,
, and , parameters K and r must also be chosen. In this case I have
treated the time period over which the share is simulated as the remaining
life of the option.
Figures 2.4 and 2.5 show three time series, the rst {S
t
}, and the second
{C
t
+Ke
r
} are given by the solid and dotted lines respectively. The third,
much smoother curve, is the series {Ke
r
}. The reason for showing the
second series instead of simply {C
t
} is to place both the share and option price
series in the same region of the graph, and is facilitated by the relationship
given in Theorem 1.1 (C
t
(S
t
Ke
r
)
+
). The series {C
t
} is still evident in
the graphs by taking the dierence of the series {C
t
+Ke
r
} and {Ke
r
}.
It is apparent that C
t
is always at least as great as S
t
Ke
r
as required.
It is also clear that the two series are highly correlated, as expected; all
movements in {S
t
} are mirrored by movements in the call price. However
this correlation is not linear, since the Black-Scholes formula is non-linear in
S
t
.
Figure 2.4 features a share price series that has S
T
< K, and so the option
matures out-of-the-money, and will not be exercised. This is reected in the
option price series, which converges to zero as the share price falls sharply in
the latter part of the series. There is a period in the middle of the share series
where S
t
< Ke
r
, and the option price becomes small, but with a reasonable
amount of time remaining, it does not disappear altogether. At this stage
there is still a good chance that the option will mature in-the-money, and
will be exercised. Whilst we see similar share prices at 0.8 and 0.2 years to
maturity, as the share price falls from this level, the option price decreases
much more quickly in the latter case, since there is little opportunity left for
the share price to rise above K.
Figure 2.5 shows a share price series that generally increases with time.
It is a realisation from the same process as the share price series in Figure
2.4 but there are clear dierences between the two. In this case the option
2.4. THE BLACK-SCHOLES FORMULA 39
Time to Maturity - Years
P
r
i
c
e
3
.
0
3
.
5
4
.
0
4
.
5
5
.
0
5
.
5
1.0 0.8 0.6 0.4 0.2 0.0
Figure 2.4: The unbroken series is a realisation of GBM with initial value
S
t
= $5 and parameters = 0.1, = 0.3, and 250 subintervals; the second
series is the Black-Scholes prices for this share series added to the present
value of the exercise price, with K = $5, and r = 0.06 and maturity at
T = 1 year; nally the smooth broken line represents the present value of
the exercise price.
price plus the present value of the exercise price converges on the share price
series, until with approximately 0.2 years to maturity the two series are
indistinguishable. In this case the share is so deep-in-the-money (S
t
K),
the probability of the share price at maturity being below the exercise price
is so small that a portfolio of the option and a cash asset Ke
r
compounding
at the risk-free rate is equivalent to a portfolio containing only the share.
Whilst the option price C
t
is a deterministic function of S
t
, for s > 0, C
t+s
will depend on a random variable S
t+s
and so C
t+s
is itself a random variable,
with density function given by Equation (2.21). It is interesting to examine
this density function for a xed value of s [0, ]. We have already seen that
when s = 0 and the option is at maturity, the distribution of call prices is
40 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
Time to Maturity - Years
P
r
i
c
e
5
.
0
5
.
5
6
.
0
6
.
5
1.0 0.8 0.6 0.4 0.2 0.0
Figure 2.5: The unbroken series is a realisation of GBM with initial value
S
t
= $5 and parameters = 0.1, = 0.3, and 250 subintervals; the second
series is the Black-Scholes prices for this share series added to the present
value of the exercise price, with K = $5, and r = 0.06 and maturity at
T = 1 year; nally the smooth broken line represents the present value of
the exercise price.
a mixed distribution given by Equation (2.12). Alternatively, for a xed s, as
T the value and distribution of a call option will converge to the value
and distribution of the share. This is nancially sensible, since as the share
pays no dividends, the only dierence between the option and the share is
the exercise payment, and is consistent with putting s = in both the
Black-Scholes formula at t + s and in the density function f
C
t+s
|S
t
(c, s)
given by Theorem 2.8. As the exercise date is moved further and further into
the future, the present value of the exercise payment shrinks to zero. Hence,
an option with innite life has the same characteristics as the share.
At time t + s, the option price distribution and its limiting properties
can be examined graphically. The rst series of graphs in Figure 2.7 shows
2.4. THE BLACK-SCHOLES FORMULA 41
the behaviour of f
C
t+s
|S
t
(c, ) as the remaining life of the option decreases to
zero (s ). The sequence of six graphs has time to maturity decreasing
from two years to approximately two weeks. The histograms in the gure
represent the distribution of simulated values of C
t+s
, with s = 1 year, and
the superimposed curve, the theoretical distribution of such prices.
As the time to maturity of the option decreases, the sequence of graphs
shows the convergence of the density function to the mixed distribution of C
T
(where s = ). We see the number of simulated option prices near zero in-
crease, and the density function approach the continuous part of the mixture
density (the truncated, translated lognormal density) and a spike at c = 0
with innite height, and area P(S
t+s
< K). Again, there is good agreement
between the histograms and the theoretical density functions, particularly
when the value of f
C
t+s
|S
t
is small. The closeness of the observed and the ex-
pected distributions stems from our ability to simulate {S
t
} with only sample
error. Hence, a good t in the S
t+s
distribution should result in a good t
to any derivative distribution. In this way, simulation provides a means of
conrming that the density functions I have derived are correct, with a close
t indicating success.
The density function, when s is small, has an interesting characteristic
which is not always apparent, and does not feature for the choice of param-
eters used in Figure 2.7. By decreasing the volatility parameter , however,
the eect is observed. Figure 2.6 shows the results of a new simulation of
5000 share prices, and the density function of its call prices with 5 months to
maturity. The density function in this case has an interesting saddle eect,
created as the probability of an option maturing out-of-the-money increases,
but the probability of it expiring at-the-money is still moderate.
Figure 2.8 shows a sequence of graphs with s increasing from 2 years
to 75 years, with two curves superimposed, and can be used to demonstrate
the behaviour of the call price distribution as time to maturity increases. The
solid curve is the theoretical density function of the call prices, and the second
42 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
0.0 0.5 1.0 1.5 2.0 2.5 3.0
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8
1
.
0
1
.
2
c
f
(
c
)
Figure 2.6: The distribution of call prices obtained using the Black-Scholes
formula on a sample of share prices S
t+s
, where s = 1 year, S
t
= $5, = 0.1,
= 0.1, K = $5, r = 0.06 and time to maturity s of 5 months. Also
shown is the theoretical density function.
broken curve is the lognormal density function of S
t+s
, and the limiting form
of f
C
t+s
|S
t
(c, ). The convergence of the option prices to the call prices is
apparent as the sample distribution and theoretical curve move along the c
axis towards the density function of the share price, until at s = 75 the
two curves are virtually indistinguishable.
2.5 Use of the Black-Scholes Model
Geometric Brownian motion is a process whose transition probability density
is known, whose moments are easily determined, and which can be accurately
simulated with minimal computing resources. In addition, the formula for a
European call option over an asset whose value follows GBM is known, and
is easily obtained, veried and evaluated. The Black-Scholes option price
2.5. USE OF THE BLACK-SCHOLES MODEL 43
depends on only ve parameters: S
t
, , K, r and , of which the rst three
are directly observable, and the fourth is relatively easy to estimate. The
model prices also have properties which are easily derived. The above anal-
ysis gives the density function for call options both at and prior to maturity.
The expected value of option prices at a time in the future, up to and in-
cluding maturity can also be determined. Black-Scholes prices are also easily
simulated. Why then is an alternative model needed, when the GBM and
Black-Scholes framework provide so many benets? The answer to this ques-
tion is that unfortunately Black-Scholes model prices do not correspond to
those observed in the market.
Even before the theoretical derivation was published, Black & Scholes
(1972) noted that the model tends to overprice options on high variance
stocks and under price options on low variance stocks. They also raise ques-
tions regarding the estimation of the nal parameter . A series of empirical
studies followed, attempting to obtain estimates of , which, when used in
the Black-Scholes formula will more closely approximate future market op-
tion prices. These studies include those by Latane & Rendleman (1976),
Chiras & Manaster (1978), and Beckers (1981). These authors, and others,
discover that market option prices yield better estimates of volatility expe-
rienced over the remaining life of the option than estimates obtained using
time series data of the share price. The estimates obtained from market op-
tion prices are called implied volatilities, and provide further evidence that
the GBM assumption of the Black-Scholes model is not appropriate.
Implied volatilities are calculated using a numerical method in much the
same way as BS
1
S
(c; t + s) was calculated for use in Equation (2.21). The
implied volatility is the solution to the equation
C
mt
= BS(; S
t
, , K, r)
where C
mt
is the market option price at time t, and BS(; S
t
, , K, r) is the
Black-Scholes function with single argument . The implied volatility is
44 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
the value of that satises the equation above. It can be interpreted as
an estimate of the forward average volatility discussed in Result 2.2. If the
Black-Scholes GBM assumption is correct, options over the same underlying
asset, with the same maturity date, should yield identical implied volatili-
ties. In fact if share price volatility is indeed constant, any option over
a particular share should yield the same implied volatility. In practice this
is not observed, and a smile relationship is seen between strike price K
and the Black-Scholes implied volatility, and a similar relationship between
time to maturity and implied volatility. Based on these phenomena, it
appears that an option pricing model which incorporates changing volatility
is required. Such a model is considered in the following chapter.
2.5. USE OF THE BLACK-SCHOLES MODEL 45
0 2 4 6 8 10
0
.
0
0
.
1
0
.
2
0
.
3
0
.
4
c
f
(
c
)
24 Months to Maturity
0 2 4 6 8 10
0
.
0
0
.
1
0
.
2
0
.
3
0
.
4
0
.
5
c
f
(
c
)
18 Months to Maturity
0 2 4 6 8 10
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8
c
f
(
c
)
12 Months to Maturity
0 2 4 6 8 10
0
.
0
0
.
5
1
.
0
1
.
5
c
f
(
c
)
6 Months to Maturity
0 2 4 6 8 10
0
.
0
0
.
5
1
.
0
1
.
5
2
.
0
2
.
5
c
f
(
c
)
3 Months to Maturity
0 2 4 6 8 10
0
1
2
3
4
c
f
(
c
)
0.5 Months to Maturity
Figure 2.7: The distribution of call prices obtained using the Black-Scholes
formula on a sample of share prices S
t+s
, where s = 1 year, S
t
= $5, = 0.1,
= 0.1, K = $5, r = 0.06 and time to maturity s ranges from 2 years
to half a month. Also the theoretical density function for these prices.
46 CHAPTER 2. GBM AND THE BLACK-SCHOLES MODEL
0 2 4 6 8 10
0
.
0
0
.
1
0
.
2
0
.
3
0
.
4
c
f
(
c
)
2 Years to Maturity
0 2 4 6 8 10
0
.
0
0
.
1
0
.
2
0
.
3
c
f
(
c
)
5 Years to Maturity
2 4 6 8 10 12
0
.
0
0
.
0
5
0
.
1
0
0
.
1
5
0
.
2
0
0
.
2
5
0
.
3
0
c
f
(
c
)
15 Years to Maturity
2 4 6 8 10 12 14
0
.
0
0
.
0
5
0
.
1
0
0
.
1
5
0
.
2
0
0
.
2
5
0
.
3
0
c
f
(
c
)
30 Years to Maturity
2 4 6 8 10 12 14
0
.
0
0
.
0
5
0
.
1
0
0
.
1
5
0
.
2
0
0
.
2
5
c
f
(
c
)
50 Years to Maturity
2 4 6 8 10 12 14
0
.
0
0
.
0
5
0
.
1
0
0
.
1
5
0
.
2
0
0
.
2
5
c
f
(
c
)
75 Years to Maturity
Figure 2.8: The distribution of call prices obtained using the Black-Scholes
formula on a sample of share prices S
t+s
, where s = 1 year, S
t
= $5, = 0.1,
= 0.1, K = $5, r = 0.06 and time to maturity s ranges from 2 to 75
years. Also the (solid) theoretical density function for these prices, and the
(dotted) lognormal density function of S
t+s
.
Chapter 3
The CEV Model
47
48 CHAPTER 3. THE CEV MODEL
3.1 Introduction
Empirical analysis of observed option prices, and observed phenomena like
the volatility smile, led researchers to formulate option pricing models that
included non-constant volatility. In response to observations of an inverse
relationship between share price and share price volatility, documented by
Fischer Black (1975), the Constant Elasticity of Variance (CEV) model was
derived. Cox (1996) suggests that the CEV model is the simplest way to
describe such an inverse relationship. In fact, the CEV model was derived
after a direct request from Fischer Black to John Cox, for a share price
evolution model that includes an inverse dependence of volatility and the
share price, as described in Cox (1996).
The standard CEV model assumes that share price S
t
evolves according
to the stochastic dierential equation:
dS
t
= S
t
dt +S

2
t
dB
t
(t > 0, < 2) (3.1)
where and are constants, and with initial condition B
0
= 0.
Unlike GBM, a solution to Equation (3.1) can become negative unless
otherwise constrained. This is clearly inappropriate for an asset price, so an
absorbing barrier must be imposed at zero, such that if S
t
= 0 then S
u
= 0
for all u > t. Note that a reecting barrier at zero is not sucient, since
once a rms share price falls to zero, the rm will be bankrupt, and the
share price cannot become positive again. The absorbing barrier, however,
overcomes this problem and is consistent with bankruptcy of the rm.
As mentioned above, the stochastic process for S
t
assumed by Black and
Scholes has = 2 in Equation (3.1). Emanuel & MacBeth (1982) consider
the above process when > 2. Hence, the option price over an underlying
asset whose price is a solution to the general SDE introduced in Denition
1.8 is known for any value of . The case when > 2 is mentioned briey
in Result 3.5 and estimated in Chapter 4, but this chapter focuses primarily
on the case < 2.
3.1. INTRODUCTION 49
The variance of the stocks instantaneous rate of return, given data to
time t is:
Var

dS
t
S
t

S
t

=
2
S
2
t
dt (3.2)
which, in the Black-Scholes case, is constant over time. In general, when
< 2, the variance of the instantaneous rate of return decreases as stock
price increases, thus loosely satisfying empirical observations.
The rate of return on a rms equity, in the absence of debt, R
a
, can be
written in the presence of debt, as a weighted average of the rates of return
on its debt and equity, R
d
and R
e
respectively:
R
a
=
S
V
R
e
+
B
V
R
d
(1 )
where S is the present value of equity, B the present value of debt, V = S+B
the present value of the rm, and reects the tax scenario
1
. Rearranging
the relationship for R
e
, and taking the variance of both sides, with random
variables R
e
and R
a
, and all other quantities assumed constant, yields:
Var(R
e
) = Var

dS
t
S
t

S
t

= Var(R
a
)

1 +
B
S

2
. (3.3)
This is the desired relationship between share price and the variance of the
stocks rate of return, since as S
t
increases relative to B
t
, the variance of its
rate of return (the constant volatility parameter in the Black-Scholes case)
will decrease, and vice versa, provided Var(R
a
) remains xed. Moreover,
as S
t
0, under the CEV model, the share price volatility will tend to
innity, as Equation (3.3) dictates. However, as S
t
, in such a way
that
B
t
S
t
0, the CEV model indicates that share price volatility should
become zero, whilst nancial theory says that it should converge to a positive
constant Var(R
a
), where this quantity remains xed. This fact is reected in
1
In a Modigliani and Miller tax world = T
c
, the corporate tax rate, but in a Miller
world, = 0. For further details, see Copeland & Weston (1988) and the references
therein.
50 CHAPTER 3. THE CEV MODEL
the compound option pricing model derived by Geske (1979) but not in the
CEV model, since under the CEV model, as share price goes to innity, the
volatility of the share price will go to zero. Therefore whilst the CEV model
is theoretically motivated by the relationship between the rms return on
equity and the value of equity outlined above, it does not fully describe this
relationship.
The CEV model acquired its name from the fact that the elasticity of
variance of the rate of return on S
t
is constant. This means that the ratio of
any proportional change in S
t
and the resulting proportional change in the
variance of the rate of return on S
t
will be constant.
The proportional change in S
t
over a period dt will be simply
dS
t
S
t
and the
proportional change in the variance of the rate of return on S
t
over the same
period dt, conditional on S
t
, will be
dVar(dS
t
/S
t
)
Var(dS
t
/S
t
)
.
Taking the ratio of these two quantities, and noting the variance of the rate
of return on S
t
given by Equation (3.2), yields the desired relationship:
dVar(dS
t
/S
t
)
Var(dS
t
/S
t
)

dS
t
S
t
=
dVar(dS
t
/S
t
)
dS
t

Var(dS
t
/S
t
)
S
t
= ( 2)
2
S
3
t
dt

2
S
2
t
dt
S
t
= 2.
where again, all variances are conditional on S
t
.
Hence, a 10% increase in S
t
will result in an increase of 10%( 2) in the
variance of the rate of return on S
t
. Note that since < 2 this will actually
be a decrease in the volatility as required.
3.2 The CEV Share Price Solution
Unlike the Black-Scholes case, for the general CEV model it is not possible to
derive a form for S
T
similar to the one we saw in Equation (2.5). According
3.2. THE CEV SHARE PRICE SOLUTION 51
to Cox & Ross (1976), the CEV option pricing formula can be derived using
the same technique that Black and Scholes used to obtain their formula.
This involves taking a transformation of the process C
t
, chosen so that its
governing PDE and boundary condition have a known solution. Both the
Black-Scholes PDE and the appropriate PDE for the CEV option price can
be transformed into the famous heat equation of physics, and solved using
standard mathematical techniques.
Cox and Ross used the CEV and other models as examples to pioneer
a pricing method called risk-neutral pricing alluded to in Section 2.4. In
order to price a future payment, P
T
, whose solution satises a PDE inde-
pendent of investor risk preferences, it may be assumed that the underlying
process has instantaneous mean r, and all future payments may be discounted
at r. Hence the value of P
T
now will be
P
t
= e
r
E

(P
T
|F
t
)
where the expectation E

is a risk-neutral expectation, taken under the as-


sumption that the underlying process has instantaneous mean r, and F
t
is
available information up to and including t. In the case of an option price,
the future payment we are interested in is P
T
= (S
T
K)
+
, where S
T
is
the underlying stochastic process. The implications of Cox and Ross result
are that if we can nd a density function that describes the evolution of P
T
between t and T, or in this particular case, of S
t
to S
T
, then we may be able
to evaluate the (risk-neutral) expected value above.
The Kolmogorov Equations can be used in this context. They are a set
of two partial dierential equations which describe the transition proba-
bilities of a Markov diusion process. The lognormal density function given
in Equation (2.14) is an example of a transition probability density for a
process following geometric Brownian motion.
Cox & Miller (1965) dene the Kolmogorov equations on page 215, which
describe properties of a continuous time, continuous variable stochastic pro-
cess X(t). These equations are dened in the following result.
52 CHAPTER 3. THE CEV MODEL
Result 3.1 (The Kolmogorov Equations). Suppose the continuous time,
continuous variable process X(t) is a solution of the SDE:
dX(t) = (x, t)dt +

(x, t)dB(t)
with initial condition X(t
0
) = x
0
. Then X(t) has instantaneous mean (x, t)
and instantaneous variance (x, t). In addition, X(t) has a transition prob-
ability density p(x
0
, t
0
; x, t) which satises the Kolmogorov equations, and
whose interpretation is given by the following equation:
P(a < X(t) < b|X(t
0
) = x
0
) =

b
a
p(x
0
, t
0
; x, t)dx.
The Kolmogorov equations are the forward equation:
1
2

2
x
2
{(x, t)p}

x
{(x, t)p} =
p
t
(3.4)
in which the backward variables x
0
and t
0
may be considered constant and
enter by way of the boundary conditions, and the backward equation:
1
2
(x
0
, t
0
)

2
p
x
2
0
+(x
0
, t
0
)
p
x
0
=
p
t
0
(3.5)
in which the forward variables x and t enter only through boundary condi-
tions.
In the CEV case we are again interested in the function f
S
T
|S
t
(s, ), which
we may use to examine the properties of the future share price S
T
, given S
t
.
It appears that this probability density function might be the solution to
the forward and backward Kolmogorov equations. S
t
is a continuous time,
continuous variable process, which satises the equation
dS
t
= S
t
dt +S

2
t
dB
t
with initial condition B
0
= 0. The process S
t
has instantaneous mean and
variance E(dS
t
|S
t
) = S
t
and Var(dS
t
|S
t
) =
2
S

t
respectively, and we intend
to nd its transition probability density
f
S
T
|S
t
(s, ) = p(s
t
, t; s, T)
3.2. THE CEV SHARE PRICE SOLUTION 53
where S
t
= s
t
is given.
One point of concern is the fact that the process S
t
has an absorbing
barrier at zero, imposed in order to ensure that the share price cannot become
negative. Cox and Miller consider this case on page 219, and state that an
additional boundary condition must be imposed when solving each of the
Kolmogorov equations. In particular, for an absorbing barrier at a, the
additional boundary condition for the forward equation is:
p(x
0
, t
0
; x, t) = 0
where x < a < x
0
, yielding for s < 0:
f
S
T
|S
t
(s, ) = 0.
It follows from Cox and Millers condition, that if x a:
P(X(t) < x|X(t
0
) = x
0
) =

p(x
0
, t
0
; u, t)du = 0
since for x < a < x
0
, the density function p is identically zero.
Thus in order to determine the density function for S
T
= s given S
t
= s
t
we must solve the backward and forward Kolmogorov equations given by:
1
2

2
s
2
{
2
s

t
f}

s
{s
t
f}
f
T
= 0 (3.6)
and
1
2

2
s

2
f
s
2
t
+s
t
f
s
t
+
f
t
= 0 (3.7)
respectively, subject to the boundary conditions:
f
S
T
|S
t
(s, ) = 0 if s < 0
f
S
T
|S
t
(s, 0|S
t
= s
t
) = (s s
t
),
where (x) is the Dirac delta function. The rst of these conditions fol-
lows from the absorbing barrier, and the second from the fact that f is a
transitional density function.
54 CHAPTER 3. THE CEV MODEL
3.2.1 Solution of the Forward Kolmogorov Equation
Feller (1951) solves the class of partial dierential equations of the form:
u
t
= (axu)
xx
((bx +c)u)
x
(3.8)
where u = u(t, x), and a, b, c are constants, and a > 0. This equation is
equivalent to the Fokker-Planck, or forward Kolmogorov equation seen in
Equation (3.4), with (x, t) = 2ax and (x, t) = bx + c. In order to apply
Fellers results to nd the CEV solution, a transformation must be made to
the process {S
t
} to obtain a partial dierential equation of the required form,
and the instantaneous mean and variance of this new process obtained.
The transformation made by Cox (1996), and by Emanuel & MacBeth
(1982), is Y = S
2
, and is applicable for all = 2. We can use It os Lemma
to obtain the instantaneous mean and variance of the new process Y
t
. By
It os Lemma, since
dS
t
= S
t
dt +S

2
t
dB
t
and Y
t
= f(S
t
) = S
2
t
,
dY
t
=
f
S
dS
t
+
1
2

2
S

2
f
S
2
dt
= (2 )S
1
t
(S
t
dt +S

2
t
dB
t
) +
1
2

2
S

t
(2 )(1 )S

t
dt
=

(2 )Y
t
+
1
2

2
(2 )(1 )

dt +(2 )

Y
t
dB
t
.
Thus, the process Y
t
has instantaneous mean:
(Y
t
) = (2 )Y
t
+
1
2

2
(2 )(1 )
and variance:
(Y
t
) =
2
(2 )
2
Y
t
.
The transition density f = f
Y
T
|Y
t
(y, ) will satisfy the forward Kolmogorov
equation:
1
2
(Y
t
)

2
f
Y
t
2
+(Y
t
)
f
Y
t
=
f
t
(3.9)
3.2. THE CEV SHARE PRICE SOLUTION 55
which is of the form specied by Feller when < 2, with
a =
1
2

2
(2 )
2
b = (2 ) c =
1
2

2
(2 )(1 )
and can be used in his result to obtain the transition density function of Y
t
.
This function is given by Feller in his Lemma 9, as:
f
Y
T
|Y
t
(y, ) =
b
a(e
b
1)
exp

b(y +Y
t
e
b
)
a(e
b
1)

ye
b
Y
t

ca
2a
I
1
c
a

2b(e
b
yY
t
)
1
2
a(1 e
b
)

(3.10)
where a, b and c are given above, and I

(z) is the modied Bessel function of


the rst kind of order . In order to obtain the transition probability density
for S
T
conditional on S
t
, we must again make a change of variables:
F
S
T
|S
t
(s, ) = P(S
T
< s|S
t
)
= P(S
2
T
< s
2
|S
2
t
)
= P(Y
T
< s
2
|Y
t
).
Dierentiating with respect to s we obtain the density function:
f
S
T
|S
t
(s, ) =

s
F
S
T
|S
t
(s, )
= (2 )s
1
f
Y
T
|Y
t

s
2
,

.
Substituting into this nal equation the constants a, b and c, and making
the replacements y = s
2
and Y
t
= S
2
t
in the density function given by
Feller, we obtain the density function for S
T
given S
t
:
f
S
T
|S
t
(s, ) = (2 )

k
1
2
( x z
12
)
1
2
1
2
e
x z
I 1
2
(2( x z)
1
2
) (3.11)
where

k =
2

2
(2 )(e
(2)
1)
x =

kS
2
t
e
(2)
z =

ks
2
(3.12)
and s > 0. This density function of S
T
conditional on S
t
, is a function of
S
t
and the time elapsed, , between t and T, but also depends on CEV
56 CHAPTER 3. THE CEV MODEL
parameters , and . It describes the statistical properties at T, of a
general process satisfying Equation (3.1), where < 2, given its value at t.
Abramowitz & Stegun (1968) give the power series expansion of the mod-
ied Bessel function seen in the density function above in their Equation
(9.6.10) as:
I

(z) = (
1
2
z)

n=0
(
1
4
z
2
)
n
n!( +n + 1)
. (3.13)
Using this identity, the Bessel function in the density function above may be
rewritten:
I 1
2
(2( x z)
1
2
) =

1
2
(2( x z)
1
2
)
1
2

n=0
(
1
4
(2( x z)
1
2
)
2
)
n
n!(n + 1 +
1
2
)
= ( x z)
1
2
1
2

n=0
( x z)
n
n!(n + 1 +
1
2
)
giving the alternative form for the transition density function:
f
S
T
|S
t
(s, ) = (2 )

k
1
2
( x z
1
)
1
2
e
x z

n=0
( x z)
n
n!(n + 1 +
1
2
)
= (2 )

k
1
2
e
x z

n=0
x
n+
1
2
z
n+
1
2
n!(n + 1 +
1
2
)
(3.14)
Probability of Bankruptcy
The density function given above is valid only for S
T
> 0. The absorbing
barrier imposed at S
u
= 0 where t < u T prevents the share price from
becoming negative, and results in a positive probability of bankruptcy under
the CEV model. The probability of bankruptcy given below is well known,
but is often stated with the unnecessary assumption = r.
Result 3.2.
G(x, 1) = 1

n=0
g(y, n +)
where G(y, ) and g(y, ) are the survivor and probability density functions
at y for a gamma random variable with shape parameter , and unit scale
parameter.
3.2. THE CEV SHARE PRICE SOLUTION 57
Proof. A proof of this result is given in Appendix B.2.
Theorem 3.1 (Probability of Bankruptcy for CEV Stocks). The prob-
ability of bankruptcy under the CEV model, with < 2, will be G( x,
1
2
)
where G(y, ) is the survivor function at y for a gamma random variable
with shape parameter and unit scale parameter, and
x =

kS
2
t
e
(2)
and

k =
2

2
(2 )(e
(2)
1)
are as previously dened.
Proof. First evaluate f
S
T
|S
t
(s, )ds. Noting that z =

ks
2
, we nd:
s =

1/(2)
ds =

k
1/(2)
1
2
z
1+1/(2)
d z.
Making this transformation, and combining with the alternate form for the
density function in Equation (3.14) yields:
f
S
T
|S
t
(s, )ds = (2 )

k
1
2
e
x z

n=0
x
n+
1
2
z
n+
1
2
n!(n + 1 +
1
2
)

1
2
z

1
2
2
d z

= e
x z

n=0
x
n+
1
2
z
n
n!(n + 1 +
1
2
)
d z (3.15)
In addition since < 2, z is a 1-1, increasing function of S
T
and when S
T
= 0,
z = 0. Hence:
P(S
T
= 0) = 1


s=0
f
S
T
|S
t
(s, )ds
= 1


z=0
e
x z

n=0
x
n+
1
2
z
n
n!(n + 1 +
1
2
)
d z
= 1

n=0
e
x
x
n+
1
2
(n + 1 +
1
2
)


0
e
z
z
n
n!
d z
= 1

n=0
g( x, n + 1 +
1
2
)
58 CHAPTER 3. THE CEV MODEL
since
g( z, ) =
e
z
z
1
()
is the gamma probability density function on z [0, ).
Finally, using Result 3.2 we can determine the probability of bankruptcy:
P(S
T
= 0) = 1

n=0
g( x, n + 1 +
1
2
)
= G( x,
1
2
) (3.16)
where
G(y, ) =


y
e
x
x
1
()
dx
is the survivor function for the gamma random variable with shape parameter
and unit scale parameter .
Hence, the probability of bankruptcy between now and T > t, for a rm
whose share price is a solution to the SDE (3.1), depends on the parameters
, and , the initial share price S
t
, and on the length of the time period
[t, T] in question. Analysis of the relationship between and the probability
of bankruptcy indicates that for a xed T, P(S
T
= 0) is insensitive to changes
in share price at t, but sensitive to changes in the size of and . As we would
expect, an increase in decreases the probability of bankruptcy for any
while an increase in volatility (via the parameter ) increases the probability
of bankruptcy. Figure 3.1 shows the relationship between and P(S
T
= 0),
with S
t
= $5, = 1 year, = 0.10, = S
/21
t
= 0.3 in the solid curve
and = 0.28 in the broken curve. Making small changes in result in very
large movements in the curve, as seen in the graph. Here a 6.67% decrease
in (from 0.3 to 0.28), via the parameter , results in a 29.64% decrease in
P(S
T
= 0) when = 2, and larger percentage decreases for larger values
of , with a 97.10% decrease in P(S
T
= 0) when = 1.
Note that since

k = when = 2, the probability of bankruptcy given
by Equation (3.16) generalises to the Black-Scholes case where P(S
T
= 0) =
3.2. THE CEV SHARE PRICE SOLUTION 59
beta
P
(
b
a
n
k
r
u
p
t
c
y
)
-2.0 -1.5 -1.0 -0.5 0.0 0.5 1.0
0
.
0
0
.
0
0
5
0
.
0
1
0
0
.
0
1
5
0
.
0
2
0
0
.
0
2
5
Figure 3.1: The relationship between and P(S
T
= 0), with S
t
= $5, = 1
year, = 0.10, = S
/21
t
= 0.3 in the solid curve and = 0.28 in the
broken curve.
0. This result is given by Markovs Inequality:
P(X x)
E(X)
x
.
Letting X be a gamma random variable, with shape parameter
1
2
, and unit
scale parameter, then:
G( x,
1
2
) = P(X x)

E(X)
x
=
1
2

2S
2
t

2
(2 )(e
(2)
1)
=

2
(e
(2)
1)
S
2
t
= 0
when = 2, and so lim
2
G( x,
1
2
) = 0 as required.
60 CHAPTER 3. THE CEV MODEL
Since the probability of bankruptcy is positive for < 2, the mixed
distribution of S
T
given S
t
can be written as a linear combination of a step
function, and a continuous distribution function:
F
S
T
|S
t
(s, ) =

x,
1
2

1 G

x,
1
2

s
0
f
S
T
|S
t
(u,)du
1G( x,
1
2
)
s 0
0 s < 0
(3.17)
Theorem 3.2 (Mean and Variance of S
T
given S
t
). The mean and vari-
ance of the CEV share price S
T
conditional on an earlier share price S
t
are
E(S
T
|S
t
) = S
t
e

and
Var(S
T
|S
t
) =

S
t
e

1
2

n=0
g( x, n + 1)
(n+1+
2
2
)
(n+1+
1
2
)
S
t
e

< 2
S
t

1
e

2
(e

1) = 1
respectively.
Proof. The expected value of S
T
given S
t
is given by:
E(S
T
|S
t
) =


s=0
sf
S
T
|S
t
(s, )ds.
The form of f
S
T
|S
t
(s, )ds is given in Equation (3.15) and s = ( z/

k)
1/(2)
,
so we can write:
E(S
T
|S
t
) =


z=0

k
1
2
e
x z

n=0
x
n+
1
2
z
n
n!(n + 1 +
1
2
)
d z
=

k
1
2

n=0
e
x
x
n
n!


0
e
z
z
n+
1
2
(n + 1 +
1
2
)
d z
= S
t
e

where the nal equality follows from the denition of x, and properties of
the gamma probability density function.
3.2. THE CEV SHARE PRICE SOLUTION 61
The expected value of S
2
T
given S
t
is found in much the same way:
E(S
2
T
|S
t
) =


z=0

k
2
2
e
x z

n=0
x
n+
1
2
z
n
n!(n + 1 +
1
2
)
d z
=

k
1
2

1
2

n=0
e
x
x
n
n!


0
e
z
z
n+
2
2
(n + 1 +
1
2
)
d z
= S
t
e

1
2

n=0
g( x, n + 1)
(n + 1 +
2
2
)
(n + 1 +
1
2
)
which yields a formula for the variance:
Var(S
T
|S
t
, ) = S
t
e

1
2

n=0
g( x, n + 1)
(n + 1 +
2
2
)
(n + 1 +
1
2
)
S
t
e

.
(3.18)
The mean square above can be simplied in the Square Root CEV case,
where = 1, to yield a variance formula that does not feature an innite
summation. Setting = 1, E(S
2
T
|S
t
) can be simplied to:
E(S
2
T
|S
t
, = 1) = S
t
e

k
1

n=0
g( x, n + 1)
(n + 3)
(n + 2)
= S
t
e

k
1

n=0
g( x, n + 1)(n + 2)
= S
t
e

k
1

n=1
e
x
x
n1
(n 1)!
+ 2

n=0
e
x
x
n
n!

= S
t
e

k
1
( x + 2)
= S
2
t
e
2
+ 2S
t
e

k
1
since when = 1, x/

k = S
t
e

. Hence:
Var(S
T
|S
t
, = 1) = E(S
2
T
|S
t
, = 1) E(S
T
|S
t
)
2
= S
2
t
e
2
+ 2S
t
e

k
1
S
2
t
e
2
= 2S
t
e

2
(e

1)
2
=
S
t
e

2
(e

1)

62 CHAPTER 3. THE CEV MODEL


since

k =
2

2
(2 )(e
(2)
1)
=
2

2
(e

1)
when = 1.
It is interesting that the mean of all CEV share prices S
T
given S
t
is
the same, regardless of . The mean also corresponds to the expected value
under GBM, however the formula for the variance is not as attractive. The
relationship between Var(S
T
|S
t
) and can be seen in Figure 3.6 later in this
section.
3.2.2 Simulation of CEV Share Prices
In the case of GBM, where the share price S
T
could be written as a function
of a standard normal variable, using SPLUS we could generate {S
t
} directly.
Whilst in some cases it is possible to generate random variables with non-
standard density functions using a uniform random variable on the interval
[0, 1], in this case the non-linearity of the density function in the argument
s makes this technology dicult to apply. Thus, in order to simulate S
T
, or
in particular the time series {S
t
}, it will be necessary to compute an approx-
imate solution of the continuous time SDE (3.1). An appropriate method
is the Euler scheme, described in Kloeden & Platen (1992) and Mikosch
(1994). This method forms a discrete approximation of the continuous time
stochastic dierential equation, writing:
S
t
i
= S
t
i1
+S
t
i1
(t
i
t
i1
) +S

2
t
i1
(B
t
i
B
t
i1
) (3.19)
where the period of interest [t, T], is partitioned into n subintervals:
t = t
0
< t
1
< < t
i
< < t
n1
< t
n
= T
not necessarily of equal length.
3.2. THE CEV SHARE PRICE SOLUTION 63
The solution can be simulated by appealing to the independent increment
property of Brownian motion:
B
t
i
B
t
i1
B
t
i
t
i1
B
0
= B
t
i
t
i1
N(0, t
i
t
i1
)
since B
0
= 0 and B
t
N(0, t). Hence xing S
t
, and generating n increments
from a normal distribution with zero mean and unit variance, the Brownian
motion increments can be obtained:
B
t
i
B
t
i1
=

t
i
t
i1
Z
i
where the Z
i
are independent N(0, 1) variables. These increments can then
be used to construct the series {S
t
} using the approximation in Equation
(3.19). Thus a single share price is given by:
S
t
i
= S
t
+
i

j=1
(S
t
j
S
t
j1
)
= S
t
+
i

j=1
S
t
j1
(t
j
t
j1
) +S

2
t
j1

t
i
t
i1
Z
i
for i = 1, 2, . . . , n. Therefore, it is clear that using this Euler scheme, an
individual share price at T > t can be calculated only by rst calculating
all previous share prices. Recall also that the Euler method discretises a
continuous process, and so the approximation will be best when t
i
t
i1
is
very small for all i. These two facts introduce computational diculties, for
the following reasons:
to improve the quality of the approximation, n, the number of subin-
tervals, should be made large, so that the time increments are small;
however, if n is large, many increments must be calculated in order to
compute elements of the series {S
t
i
}, when i is large. Thus increasing
n decreases the speed of the computation.
64 CHAPTER 3. THE CEV MODEL
Having xed the number of subintervals, the Euler scheme provides the
discrete time series {S
t
i
}. The continuous time process is then approx-
imated by linear interpolation of the points (t
i1
, S
t
i1
) and (t
i
, S
t
i
), for
i = 1, 2, . . . , n.
The function that I have used to simulate CEV share prices can be seen in
Appendix D.3. A parameter of this function is the volatility of the share price,
, which assuming Black-Scholes evolution, is equal to the standard deviation
of the rate of return on S
t
. When the volatility is estimated empirically based
on historical share price data, it is usually computed using the formula

2
=
1
t

n
i=1
(r
i
r)
2
n 1
where r
i
= ln S
t
i+1
ln S
t
i
, r =
1
n

r
i
, and t = t
i+1
t
i
for all i, as given
in Hull (1997) on page 233. This is simply the annualised variance of the
daily returns on the share. Estimating volatility in this way assumes that
the share price is following geometric Brownian motion, or at least that the
volatility is independent of share price, since any intra-data relationship is
lost by taking a global average. In the CEV case volatility is a function
of share price as seen in Equation (3.2). This relationship can be used to
translate an empirically sensible volatility into a value of according to the
share prices .
Both Beckers (1980) and MacBeth & Merville (1980) compare CEV and
Black-Scholes option prices for various share price processes. In order to
make valid comparisons, these processes must be aligned in some way so
that the dierences in the share price properties (and hence in the option
price properties) are due only to the form of the variance, rather than that
the processes are intrinsically dierent in nature. If realisations of the pro-
cesses did not look similar, we could not expect option prices based on these
processes to be comparable. Since there are systematic dierences between
CEV processes with dierent , any alignment process is restricted to a sin-
gle point in time. Beckers chooses to align the share price processes at S
T
,
3.2. THE CEV SHARE PRICE SOLUTION 65
by choosing so that S
T
has the same variance regardless of . MacBeth
and Merville align the processes at the beginning of the simulation period.
More specically, MacBeth & Merville align dierent processes by setting
the variance of the rate of return of each process to be the same at the
beginning of the simulation period. GBM is the solution to the SDE:
dS
t
S
t
= dt +dB
t
.
Using MacBeth and Mervilles alignment procedure, a comparable CEV pro-
cess would satisfy the SDE:
dS
t
S
t
= dt +S
1

2
t
0
S

2
1
t
dB
t
so that for t = t
0
both processes would have the same SDE, and in particular
the rate of return on each process would have the same initial variance. Hence
MacBeth and Merville obtain using the equation:
= S
1

2
t
0
. (3.20)
Beckers adopts a dierent approach. Instead of aligning the processes at
the beginning of the simulation period, Beckers determines the appropriate
value for , by ensuring Var(S
T
|S
t
) is the same for each process considered.
For general , this is a lot more dicult than MacBeth and Mervilles ap-
proach, and requires numerical solution. Whilst E(S
T
|S
t
) is easy to compute
as seen in the proof of Theorem 3.2, we also saw that the variance is not easy
to calculate in general.
Compared to Beckers method, MacBeth and Mervilles method is cer-
tainly easier to implement for any value. Although Beckers approach
might be more appropriate, given our interest in S
T
for the purposes of valu-
ing options, this alignment requires numerical solution for = 1, and has
introduced complications that are perhaps unnecessary. On this basis, I have
elected to use the alignment procedure of MacBeth & Merville. This is ev-
ident in the program cevS.f seen in Appendix D.3 that I use to simulate
66 CHAPTER 3. THE CEV MODEL
share price. In this function, I call the volatility as a parameter, and then
use the relationship in Equation (3.20) to determine for use in the Euler
Equation (3.19).
3.2.3 CEV Share Price Series
For the purpose of pricing European options, analysis of share price evolution
can be restricted to the distribution of possible share price values at the
exercise date of the option. This distribution, and the risk-neutral pricing
technology of Cox and Ross, enables the estimation of the present value
of the option exercise payo. In order to obtain the distribution of a future
share price, either an appropriate form of the Kolmogorov Equations must be
solved, or the distribution estimated using simulation. In order to do either
of these things, a decision must be made about how to model the evolution
of share price based on properties of the past and present share price series.
Hence examining time series of CEV share prices will be benecial in the
option pricing setting in that it will indicate features of an appropriate model,
which may then be applied to option pricing.
Figures 3.2 and 3.3 contain time series {S
t
} for CEV processes with S
t
=
$5, = 1 year, = 0.1, = 0.3, n = 250 subintervals, and the same
Brownian motion increments, {B
t
}. The processes have values of 2 (GBM)
and -1 respectively. The gures each show three graphs, the rst of which is
simply the share price series. Since the series have been generated using the
same Brownian motion increments, we would expect them to be similar, and
in this case it is very dicult to see any dierence at all. Comparison of the
nal price in each series shows that the CEV process has fallen further than
the GBM realisation, but aside from this, dierences are dicult to detect.
The second graph in each gure shows the daily return series {R
t
}, where
R
t
= ln S
t+t
ln S
t
3.2. THE CEV SHARE PRICE SOLUTION 67
for each process
2
, where for daily returns, t =
1
250
years is approximately
one trading day. Superimposed on the daily returns is an estimate of the
mean level of the daily returns, calculated using a Lowess lter with a smooth-
ing window of 30 days. Since the lter is based on a symmetric window about
the individual points, as before, 15 estimates have been removed from either
end so that all estimates of the mean level are based on actual daily returns
and not back- or forecasted values. The estimated standard deviation of the
daily returns has been calculated using the Lowess lter and the estimate
of the mean for mean-correction, and has been restricted in the same way.
Lines which are two standard deviations from the mean have superimposed
on the daily return series.
Whilst in the CEV case the standard deviation of the daily returns is a
function of the share price level, in the Black-Scholes case it is a constant.
This suggests that the mean two standard deviation limits in the second
graph in Figure 3.2 should be approximately equidistant over the entire series
{R
t
}, since the series is GBM. Conversely, a CEV process with parameter
= 1 has an inverse relationship between share price level and volatility,
and so we should see a widening of the bounds when share price is low,
and an opposite eect when the share price is high. Due to the way I
have aligned the processes, the classication of the share price as low or
high depends on the initial share price S
t
. That this should be so, follows
by examining the volatility for the general process, with t < u < T:
Var

dS
u
S
u

S
u

=
2
S
2
u
du
=
2
S
2
t
S
2
u
du
=
2

S
t
S
u

2
du
2
In general, when dividends are paid on the stock, the daily returns should be calculated
using
R
t
= ln(S
t+t
+ d
t
) ln S
t
where d
t
is the dividend paid at t.
68 CHAPTER 3. THE CEV MODEL
and since < 2, the relationship between share price and the variance of its
instantaneous rate of return is an inverse one. Furthermore, when S
u
< S
t
,
the volatility will be greater than , and when S
u
> S
t
, the volatility will be
less than .
Dierences between the daily return series for the CEV process in Figure
3.3 and the same series for the GBM process in Figure 3.2 are easier to see
than dierences between the raw share price series. In particular the series
are very dierent near the end of the graph, which, on close inspection, is
one region of the share price series where a dierence is apparent.
The third graph in each respective gure does show clearly the dierence
between the two processes. In the case of the geometric Brownian motion,
there does not seem to be any clear relationship between share price level
and the standard deviation of the daily returns. The standard deviation
should be constant, a fact which is not entirely supported by the graph.
This is not overly alarming since we are dealing with a single realisation of
a process, and examining a property that holds in continuous time using
non-parametric smoothing technology. Comparison of this scatterplot to the
third graph of the CEV process shows highly evident dierences. Here we
see a decreasing relationship between share price level, and the standard
deviation of its daily returns. The relationship does not appear to be linear,
but it is certainly decreasing, in conrmation of what we know to be true for
a CEV process with < 2.
3.2. THE CEV SHARE PRICE SOLUTION 69
Time - years
S
h
a
r
e

P
r
i
c
e
0.0 0.2 0.4 0.6 0.8 1.0
3
.
5
4
.
0
4
.
5
5
.
0
5
.
5
Time - years
L
o
g
-
r
e
t
u
r
n
s
0.0 0.2 0.4 0.6 0.8 1.0
-
0
.
0
8
-
0
.
0
6
-
0
.
0
4
-
0
.
0
2
0
.
0
0
.
0
2
0
.
0
4

Share Price
L
o
g
-
r
e
t
u
r
n

S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
3.5 4.0 4.5 5.0 5.5
0
.
0
1
0
0
.
0
1
1
0
.
0
1
2
0
.
0
1
3
0
.
0
1
4
Figure 3.2: Firstly, a typical realisation of GBM, with S
t
= $5, = 1
year, = 0.10, = 0.3 and n = 250 subintervals; secondly, the daily
returns for this series with estimated mean, and mean 2 standard deviation
series; thirdly, a plot of the share price level against the estimated standard
deviation of the daily returns.
70 CHAPTER 3. THE CEV MODEL
Time - years
S
h
a
r
e

P
r
i
c
e
0.0 0.2 0.4 0.6 0.8 1.0
2
.
5
3
.
0
3
.
5
4
.
0
4
.
5
5
.
0
5
.
5
Time - years
L
o
g
-
r
e
t
u
r
n
s
0.0 0.2 0.4 0.6 0.8 1.0
-
0
.
0
8
-
0
.
0
4
0
.
0
0
.
0
2
0
.
0
4
0
.
0
6

Share Price
L
o
g
-
r
e
t
u
r
n

S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
3.0 3.5 4.0 4.5 5.0 5.5
0
.
0
1
0
0
.
0
1
2
0
.
0
1
4
0
.
0
1
6
0
.
0
1
8
0
.
0
2
0
Figure 3.3: Firstly, a typical realisation of share price, with S
t
= $5, = 1
year, = 0.10, = 0.3 and n = 250 subintervals and CEV parameter
= 1; secondly, the daily returns for this series with estimated mean, and
mean 2 standard deviation series; thirdly, a plot of the share price level
against the estimated standard deviation of the daily returns.
3.2. THE CEV SHARE PRICE SOLUTION 71
3.2.4 Graphical Examination of S
T
The theoretical distribution for CEV share prices at T, given an initial start-
ing value at t, is given by Equation (3.11), with an alternative form in Equa-
tion (3.14). Both these (improper) density functions present problems in
terms of computation. In the rst case, the Bessel function I

(z) is not inter-


nally computed in SPLUS, and in the second, there is an innite summation
3
.
An alternative is due to Schroder (1989), who discusses computation of
the CEV option price. Whilst not the focus of his paper, Schroder represents
the transition survivor function of S
T
given S
t
in terms of a non-central Chi-
squared random variable. Johnson, Kotz & Balakrishnan (1995) introduce
the non-central Chi-squared distribution on page 433 as in the following
result.
Result 3.3 (The Non-central
2
Distribution). If U
1
, U
2
, . . . , U

are in-
dependent unit normal random variables, and
1
,
2
, . . . ,

are constants
then:

j=1
(U
j
+
j
)
2
(3.21)
has a non-central
2
distribution, with degrees of freedom, and non-centrality
parameter:
=

j=1

2
j
.
The density function of such a variable is given as:
p(y; , ) =
exp(
1
2
(y +))
2
1
2

j=0
(y)
1
2
+j1

j
(
1
2
+j)2
2j
j!
. (3.22)
3
It does appear that the terms in the summation should converge very quickly to zero,
due to the presence of both n! and ( +n+1) in the denominator. Together these terms
are like n!
2
and will quickly dominate the term in the numerator, suggesting that the
summation should converge after few terms.
72 CHAPTER 3. THE CEV MODEL
Given the denition of Johnson et al., it appears Z
+
is required, how-
ever the moment generating function for a non-central Chi-squared variable
is dened for all > 0. This moment generating function:
M
X
(t) = (1 2t)

1
2

exp

t
1 2t

uniquely denes the non-central Chi-squared variable, and so non-integer


degrees of freedom are permitted. This is noted by Johnson et al. Note also
that must be positive.
Using the series expansion of the modied Bessel function shown in Equa-
tion (3.13) the density function p(y; , ) can be manipulated to give:
p(y; , ) =
1
2
(y/)
1
4
(2)
exp

1
2
( +y)

I1
2
(2)
(

y) (3.23)
which is the same as that given by Johnson et al. in their Equation (29.4).
Beginning with Equation (3.23), the equivalence of the two forms of the
density function is demonstrated below.
p(y; , ) =
1
2
(y/)
1
4
(2)
e

1
2
(+y)
I1
2
(2)
(

y)
=
1
2
(y/)
1
4
(2)
e

1
2
(+y)
(
1
2

y)
1
2
(2)

j=0
(
1
4
(

y)
2
)
j
j!(
1
2
( 2) +j + 1)
= (
1
2
)
1
2

y
1
2
(2)
e

1
2
(+y)

j=0

j
y
j
2
2j
j!(
1
2
+j)
The last equation is of course the same as Equation (3.22).
Theorem 3.3 (The CEV Share Price Distribution Function). The tran-
sition distribution function for a CEV share price S
T
given S
t
,
F
S
T
|S
t
(s, ) = P(S
T
< s|S
t
)
is given by the equation:
F
S
T
|S
t
(s, ) =

0 s < 0
G( x,
1
2
) s = 0
Q(2 x;
2
2
, 2 y) s > 0
3.2. THE CEV SHARE PRICE SOLUTION 73
where y =

ks
2
,

k and x are dened in Equation (3.12), and Q(x; , )
is the survivor function at x for a non-central Chi-squared variable with
degrees of freedom and non-centrality parameter .
Proof. Note rstly that S
T
0, so that for s = 0, P(S
T
< s|S
t
) = 0.
Secondly, P(S
T
= 0|S
t
) is given by Theorem 3.1, and is G( x,
1
2
) as required.
I will defer the proof for the nal case, where s > 0, until Section 3.5.2, since
the proof is made considerably easier by results which follow.
Thanks to Schroders result, and the fact that the non-central Chi-squared
cumulative probability function is an internal function in SPLUS, we can
again compare the theoretical distribution for share price at a future time T,
to an empirical distribution of simulated values. Using the Euler method, I
have simulated 5000 share prices = 1 year into the future, with = 1, and
additional parameters S
t
= $5, = 0.1, = 0.3 and n = 250 subintervals.
Of these simulated series, 38 had nal values S
T
= 0, giving an estimate of
P(S
T
= 0) of
38
5000
= 0.0076. This is less than the true probability of 0.00896,
corresponding to an expected number of bankruptcies of 44.8.
A histogram of the remaining 4962 values is shown in Figure 3.4 along
with the density function for a GBM process with the same parameters (plot-
ted as a broken line), and the true density function (plotted as a solid line)
conditional on S
T
> 0, calculated using an approximation to Equation (3.14):
f
S
T
|S
t
(s, ) = (2 )

k
1
2
e
x z
100

n=0
x
n+
1
2
z
n+
1
2
n!(n + 1 +
1
2
)
where the upper limit of the summation has been replaced by 100. In fact,
remarkable accuracy can be achieved using only the rst 11 terms of the
summation, with a maximum dierence of only 0.00005555 between the two
approximations, where both are calculated at 500 values of S
T
in the range
[0, 10.4]. The theoretical curve is a true density function, which is formed by
scaling the function f
S
T
|S
t
(s, ) above as seen in Equation (3.17):
f
S
T
|S
t
(s, |S
T
> 0) =
f
S
T
|S
t
(s, )
1 G( x,
1
2
)
.
74 CHAPTER 3. THE CEV MODEL
0 2 4 6 8 10
0
.
0
0
.
0
5
0
.
1
0
0
.
1
5
0
.
2
0
0
.
2
5
0
.
3
0
Share Price
R
e
l
a
t
i
v
e

F
r
e
q
u
e
n
c
y
Figure 3.4: 5000 realisations of S
T
, a future CEV price with = 1, with
S
t
= $5, = 1 year, = 0.1 and = 0.3, the (solid) theoretical density for
these prices, and the lognormal density function with the same parameters.
In Figure 3.4, we see that again there is good agreement between the
simulated share prices and theory. Unlike the GBM equivalent seen in Figure
2.3, in this case there are two sources of error, due to sampling error and use
of the Euler approximation for the solution to the SDE (3.1). The close t
of the density function to the histogram suggests that aggregate errors in
the Euler method of simulating share price under the CEV model have been
small.
We can also compare the empirical cumulative distribution function to
the theoretical one, which, thanks to Schroder, can be computed directly.
These functions are shown in Figure 3.5 where the solid line represents the
theoretical curve and the broken line the empirical results from the sample
shown in Figure 3.4,with S
t
= $5, = 1, = 0.1, = 0.3 and = 1.
Even using fairly coarse subdivisions for the estimation of the empirical
3.2. THE CEV SHARE PRICE SOLUTION 75
s
P
(
S
h
a
r
e

P
r
i
c
e

<

s
)
0 2 4 6 8 10
0
.
0
0
.
2
0
.
4
0
.
6
0
.
8
1
.
0
Figure 3.5: The empirical cumulative distribution function of the 5000 re-
alisations of S
T
shown in Figure 3.4, a future CEV price with = 1,
with parameters S
t
= $5, = 1, = 0.1 and = 0.3, and the theoretical
distribution function for these prices.
curve, the empirical and theoretical distributions are virtually indistinguish-
able.
Estimating the sample mean and standard deviation for all 5000 reali-
sations yields estimates

S
T
= 5.5096, and s(S
T
) = 1.5516, which are both
below the theoretical values of 5.5259 and 1.5782, despite the fact that fewer
bankruptcies were observed than expected. These dierences are not signi-
cant at the 5% level
4
.
In Theorem 3.2 I derived a form for the variance of a future CEV share
price S
T
, given S
t
and . The variance is given in Equation (3.18) and is
used to calculate the theoretical standard deviation for the sample above.
4
A two-sided test of H
0
: = 5e
0.1
yields a test statistic of -0.7293, and a p-value of
0.4658. Similarly a two-sided test of H
0
:
2
= 1.5782 yields a test statistic of 4831.91
and a p-value of 0.0923.
76 CHAPTER 3. THE CEV MODEL
Using SPLUS, it is possible to calculate the standard deviation of S
T
given
S
t
by restricting the innite summation to a nite number of terms. This
computation fails when is close to two, since the quantile at which the
gamma density function must be evaluated grows very large. Increasing the
shape parameter, and the upper limit of the summation does not solve the
problem since both (n + 1 +
i
2
) terms, where i = 1, 2, become too large,
even though their ratio is likely to remain moderate in comparison. Figure
3.6 shows the standard deviation function for 2 2, and the additional
parameters S
t
= $5, = 1 year, = 0.1 and = 0.3. Due to computation
problems the standard deviation for 1.5 < < 2 has been estimated by
linear interpolation using the standard deviation when = 1.5 found using
the approximation, and that for = 2, given by Equation (2.7).
beta
S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n

o
f

S
h
a
r
e

P
r
i
c
e
-2 -1 0 1 2
1
.
5
8
1
.
6
0
1
.
6
2
1
.
6
4
1
.
6
6
1
.
6
8
1
.
7
0
Figure 3.6: The standard deviation of a future CEV share price S
T
, with
S
t
= $5, = 1 year, = 0.1 and = 0.3, for 2 2.
The relationship shown in the graph is not monotonic, with the variance
decreasing as decreases from 2 to approximately -0.50, after which the
3.3. PROPERTIES OF C
T
- THE EXERCISE PAYOFF 77
variance begins to increase.
3.3 Properties of C
T
- the Exercise Payo
Many results proved for the GBM case apply to the CEV exercise payo
also. In particular the form for the probability density function of C
T
given
S
t
, derived in Theorem 2.3 holds, except of course the functions F
S
T
|S
t
(s, )
and f
S
T
|S
t
(s, ) are dierent. In addition we saw that E(C
T
|S
t
) is very sim-
ilar to the price of the option at t, but in future value terms, and with
present in the solution instead of r. In the case of CEV exercise payos I will
restrict myself to noting the form of the cumulative distribution function of
the payo. A graphical representation of both the theoretical and simulated
exercise payos follows from Figure 3.5 by setting F
S
T
|S
t
(s, ) = 0 for s < K,
and repositioning the curve, moving the origin to s = K. The shape of both
curves will be identical for s > K. This result is stated and proved in the
following Theorem.
Theorem 3.4 (The Distribution of C
T
given S
t
). At exercise, the call
option will deliver
C
T
=

0 S
T
K
S
T
K S
T
> K
(3.24)
the cumulative distribution function of which is, given S
t
:
F
C
T
|S
t
(c, ) =

0 c < 0
Q(2 x;
2
2
, 2

kK
2
) c = 0
Q(2 x;
2
2
, 2

k(K +c)
2
) c > 0
(3.25)
where x and

k are dened in Equation (3.12).
Proof. For K > 0:
P(C
T
= 0|S
t
) = P(S
T
< K|S
t
)
= Q(2 x;
2
2
, 2

kK
2
)
78 CHAPTER 3. THE CEV MODEL
from Theorem 3.3. Likewise, for c > 0
P(C
T
< c|S
t
) = P(S
T
K < c|S
t
)
= P(S
T
< K +c|S
t
)
= Q

2 x;
2
2
, 2

k(K +c)
2

again using the distribution function of S


T
given in Theorem 3.3.
3.4 The CEV Option Pricing Formula
The price of a European option over a stock whose share price evolves ac-
cording to Equation (3.1), was derived by John Cox and circulated as an
unpublished note
5
, which was summarised in Cox (1996). In addition, two
special cases of the CEV model, the Absolute, and Square Root CEV models,
were described in Cox & Ross (1976). The derivation of these models used
the risk-neutral pricing method discussed in Section 2.4, as an alternative to
the classical method used by Black and Scholes. The risk-neutral method is
applicable because again the option price may be described using an equation
which is independent of investor risk preferences.
The assumptions of the CEV model are:
the instantaneous interest rate is known, and constant;
share price is a solution to the SDE (3.1), which implies:
the parameters and are constant, and known;
no dividends are paid on the share over the life of the option;
there are no transaction costs, dierential taxes, or short-selling restric-
tions, and it is possible to trade any fraction of the stock or option.
5
John Cox (1975), Notes on option pricing I: constant elasticity of variance diusions,
unpublished note, Stanford University, Graduate School of Business.
3.4. THE CEV OPTION PRICING FORMULA 79
The only dierence between these assumptions and those of Black and Sc-
holes are those regarding the way share price evolves over time. All other
assumptions are the same.
Theorem 3.5 (The CEV Option Price PDE). If S
t
is a solution to the
SDE (3.1), then the price of a European call option C
t
, with time to ma-
turity, must satisfy the partial dierential equation (PDE):
1
2

2
S

2
C
S
2
+rS
C
S
+
C
t
rC
t
= 0 (3.26)
subject to the boundary condition
C
T
= (S
T
K)
+
where r is the continuously compounding risk-free rate.
Proof. The CEV option price PDE follows from Theorem 2.5, with
(S
t
, t) = S

2
1
t
as does the boundary condition.
As in the Black-Scholes case, the PDE (3.26) which the option value must
satisfy, is independent of and is hence independent of investor preferences.
Cox and Ross thus infer that the option may be valued assuming any investor
preferences, and in particular, assuming risk-neutrality. Why this should be
so can be seen by applying the Kolmogorov Equations introduced in Result
3.1 to their solution.
Theorem 3.6 (The Risk-Neutral CEV Solution). The correct solution
C
t
, of the PDE (3.26) subject to the boundary condition C
T
= (S
T
K)
+
is
given by the expectation equation:
C
t
= C(S
t
, ) = e
r
E

{(S
T
K)
+
|S
t
}
where E

is an expectation using a risk-neutral transition density function


for share price with the replacement = r, and r is the continuously com-
pounding risk-free rate.
80 CHAPTER 3. THE CEV MODEL
Proof. Considering C in the form
C(S
t
, ) = e
r
P(S
t
, )
will yield the partial derivatives
C
S
= e
r
P
S

2
C
S
2
= e
r

2
P
S
2
C

= re
r
P +e
r
P

which can be substituted in Equation (3.26) to give the similar PDE for the
function P:
1
2

2
S

2
P
S
2
+rS
t
P
S

P

= 0 (3.27)
and boundary condition C
T
= P
T
= (S
T
K)
+
. From the relationship
between P and C, the form of P(S
t
, t) is known, and its partial derivatives
can be evaluated:
P(S
t
, t) = E

{(S
T
K)
+
|S
t
} =


s=K
(s K)f

S
T
|S
t
(s, )ds
and so:
P
S
=


K
(s K)
f

S
ds

2
P
S
2
=


K
(s K)

2
f

S
2
ds
P


K
(s K)
f

ds.
Using the above partial derivatives, the left hand side of Equation (3.27) can
be evaluated to give:


K
(s K)

1
2

2
S

2
f

S
2
+rS
t
f

S

f

ds (3.28)
in which a risk-neutral transition density function, f

, is being dierentiated
with respect to the backward variables S
t
= S and t. The backward Kol-
mogorov Equation (3.7) states that the transition density for a general CEV
process will satisfy the PDE:
1
2

2
S

2
f
S
t
2
+S
t
f
S
t
+
f
t
= 0.
3.4. THE CEV OPTION PRICING FORMULA 81
Thus, the transition density for a process with = r will satisfy the backward
Kolmogorov Equation with replaced by r, and for such a process
C(S
t
, t) = e
r
E

{(S
T
K)
+
|S
t
} (3.29)
is a solution of (3.26).
We know the transition density function for the general CEV process, in
which we can replace by r, and form the risk-neutral density function for
S

T
given S
t
, where S

T
is a random variable that is a solution to the SDE:
dS

t
= rS

t
dt +S

2
t
dB
t
(3.30)
subject to the initial condition S

t
= S
t
. I will denote the density function
for this variable, conditional on S
t
: f

S
T
|S
t
(s, ).
Note also that Equation (3.29) can be rewritten:
C(S
t
, t) = e
r
E

{(S
T
K)
+
|S
t
}
= e
r


K
(s K)f

S
T
|S
t
(s, )ds
= e
r


K
sf

S
T
|S
t
(s, )ds Ke
r


K
f

S
T
|S
t
(s, )ds
= e
r
E

(S
T
|S
t
, S
T
> K)P

(S
T
> K|S
t
) Ke
r
P

(S
T
> K|S
t
)
(3.31)
where P

(.) is a risk-neutral probability whose denition follows from the


nal equations above, and since, given S
T
> K, the correct risk-neutral
density function for S
T
given S
t
is
f

S
T
|S
t
,S
T
>K
(s, ) =
f

S
T
|S
t
(s, )
P

(S
T
> K|S
t
)
.
3.4.1 The CEV Solution
The solution to the CEV partial dierential equation has been outlined by
various people, with conicting results. Most of the disagreement can be
82 CHAPTER 3. THE CEV MODEL
attributed to typographical errors, but I believe one error in particular is
genuine. In order to shed more light on the dierent versions of the CEV
solution published, I will attempt to employ consistent notation, and identify
and correct inconsistencies.
Cox (1996) presents the CEV solution option pricing formula, and the
risk-neutral density function from which it was derived. Comparison of this
solution with that in Cox & Ross (1976) for the special case = 1 (the
Square Root CEV model) indicates that the density function given in Cox
(1996) is incomplete. Ignoring dividends, Coxs risk-neutral density function
should read, for s > 0:
f

S
T
|S
t
(s, ) = (2 )k
1
2
(xz
12
)
1
2
1
2
e
xz
I 1
2
(2(xz)
1
2
) ( < 2)
(3.32)
where:
k =
2r

2
(2 )(e
r(2)
1)
x = kS
2
t
e
r(2)
z = ks
2
(3.33)
with s = S
T
, and the missing term e
xz
is inserted. As we saw earlier,
using the power series expansion of the modied Bessel function yields an
alternative form for the risk-neutral density function:
f

S
T
|S
t
(s, ) = (2 )k
1
2
e
xz

n=0
x
n+
1
2
z
n+
1
2
n!(n + 1 +
1
2
)
.
The risk-neutral density function shown in Equation (3.32) can be used
to obtain a formula for the option price given by Cox.
Theorem 3.7 (The CEV Option Pricing Formula). The solution to Equa-
tion (3.26) subject to the boundary condition C
T
= (S
T
K)
+
is given by
the formula:
C
t
= S
t

n=0
e
x
x
n
G

kK
2
, n + 1 +
1
2

(n + 1)
Ke
r

n=0
e
x
x
n+
1
2
G

kK
2
, n + 1

(n + 1 +
1
2
)
3.4. THE CEV OPTION PRICING FORMULA 83
where g(x, ) and G(y, ) are the gamma probability density and survivor
functions respectively, with shape parameter and unit scale parameter.
Proof. From Theorem 3.5 and the results of Cox & Ross (1976) we can use
the risk-neutrality argument to give Coxs option pricing formula. Thus, the
solution can be obtained by evaluating:
C(S
t
, t) = e
r


K
(s K)f

S
T
|S
t
(s, )ds.
Note that since z = ks
2
, when s = S
T
= K then z = kK
2
. Again
drawing parallels to previous results, and in particular Equation (3.15), we
can make the change of variable to z:
f

S
T
|S
t
(s, )ds = e
xz

n=0
x
n+
1
2
z
n
n!(n + 1 +
1
2
)
dz.
Noting x = kS
2
t
e
r(2)
, the solution takes the form:
C(S
t
, t) = e
r


z=kK
2

z
k
1
2
K

e
xz

n=0
x
n+
1
2
z
n
n!(n + 1 +
1
2
)
dz
= e
r


kK
2
e
xz

n=0
x
n
(x/k)
1
2
z
n+
1
2
Kx
n+
1
2
z
n
n!(n + 1 +
1
2
)
dz
= e
r


kK
2
e
xz

n=0
x
n
S
t
e
r
z
n+
1
2
Kx
n+
1
2
z
n
n!(n + 1 +
1
2
)
dz
= S
t

n=0
e
x
x
n
n!


kK
2
e
z
z
n+
1
2
(n + 1 +
1
2
)
dz
Ke
r

n=0
e
x
x
n+
1
2
(n + 1 +
1
2
)


kK
2
e
z
z
n
n!
dz (3.34)
which is the required solution, and so consistent with the conditional density
function for S
T
given S
t
in Equation (3.32) above.
It is not a trivial matter to show directly that this solution satises the partial
dierential equation above, nor that the density function satises the forward
equation. Despite this, the CEV option prices exhibit limiting qualities that
instill condence in the solution, as does the earlier comparison of CEV share
prices to their theoretical distribution.
84 CHAPTER 3. THE CEV MODEL
3.4.2 Reconciling Various Forms of the CEV Solution
Coxs option pricing formula for the CEV model with < 2, as given in Equa-
tion (3.34), is consistently reported in papers by Beckers (1980), Emanuel &
MacBeth (1982), MacBeth & Merville (1980) and Schroder (1989). Further-
more the solution that appears in Jarrow & Rudd (1983) on page 154 is also
consistent with that of Cox, however, this solution cannot be obtained by
integration of the risk-neutral density function also given in this text.
The risk-neutral density function given by Jarrow and Rudd is:
f

S
T
|S
t
(s, ) = e
r

n=0
g

t
, n + 1
1

g((se
r
)

, n + 1) (3.35)
where:
=
2r

2
(e
r
1)
= 2.
To identify the function that should appear in Jarrow and Rudds notes, the
risk-neutral density given in Equation (3.32) can be written in Jarrow and
Rudds notation. Comparison of the two density functions, and noting the
denitions of k, x, and z, yields immediately the relationships:
k = e
r
x = S

t
z = (se
r
)

.
These can be substituted into Coxs risk-neutral density function to give:
f

S
T
|S
t
(s, ) = (2 )k
1
2
e
xz

n=0
x
n+
1
2
z
n+
1
2
n!(n + 1 +
1
2
)
= (e
r
)

e
xz

n=0
(S

t
)
n
1

((se
r
)

)
n+1+
1

n!(n + 1
1

)
= e
r
s
1
1

n=0
(S

t
)
n
1

e
S

t
(n + 1
1

)
((se
r
)

)
n
e
(se
r
)

(n + 1)
= e
r
s
1
1

n=0
g(S

t
, n + 1
1

)g((se
r
)

, n + 1)
3.5. COMPUTING THE OPTION PRICE 85
This nal equation is clearly dierent to the density given by Jarrow and
Rudd, who have a constant e
r
multiplying the sum. Since the risk-
neutral density given in Equation (3.32) yields the option pricing formula
given by Cox, computing e
r
E

((S
T
K)
+
|S
t
) using the risk neutral density
function given by Jarrow and Rudd cannot lead to the required formula.
3.5 Computing the Option Price
The option pricing formula given by Cox appears formidable, especially com-
pared to the industry standard Black-Scholes formula. Empirical papers that
consider the analysis of simulated CEV prices include Beckers (1980) and
MacBeth & Merville (1980). These authors produce prices by limiting the
innite summations to a nite number of terms:
C
t
S
t
n
2

n=n
1
g(x, n + 1)G

kK
2
, n + 1 +
1
2

Ke
r
n
2

n=n
1
g

x, n + 1 +
1
2

G(kK
2
, n + 1)
(3.36)
where x and k are dened in Equation (3.33), and where n
1
and n
2
are cho-
sen to ensure convergence of the solution
6
. Alternatively, these authors and
others, including Rubinstein (1985), focus their attention on special cases of
the CEV class for which closed form solutions or ecient numerical approx-
imations existed. In particular, there is a closed form solution for Absolute
CEV prices, where = 0, and a numerical approximation for the Square
Root CEV prices, where = 1.
3.5.1 The Absolute CEV Model
In the Absolute CEV model, share price evolves according to the SDE:
dS
t
= S
t
dt +dB
t
(3.37)
6
Beckers uses n
1
= 1 and n
2
= 995.
86 CHAPTER 3. THE CEV MODEL
which is an Ornstein-Uhlenbeck process with an absorbing barrier at zero.
Cox & Ross (1976) give a form for the risk-neutral transitional density func-
tion with = 0:
f

S
T
|S
t
(s, | = 0) =
1

2W
t

exp

(s S
t
e
r
)
2
2W
t

exp

(s +S
t
e
r
)
2
2W
t

(3.38)
where W
t
=

2
2r
(e
2r
1). Using the formula in Equation (3.29) and the
density function above yields the closed form solution for the option price
when = 0:
C
abs
t
= (S
t
Ke
r
)(d
t
) + (S
t
+Ke
r
)(y
t
) +v
t
((d
t
) (y
t
)) (3.39)
where (x) is the unit normal probability density function at x, (x) is the
unit normal cumulative distribution function, and:
v
t
=

1 e
2r
2r
1
2
d
t
=
S
t
Ke
r
v
t
y
t
=
S
t
Ke
r
v
t
.
It is relatively simple to obtain the solution from the risk-neutral density
function in the usual way, and in this case it is also easy to show by evalu-
ating partial derivatives, that the solution (3.39) is consistent with the PDE
(3.26) with = 0. This solution is as easy to compute as the Black-Scholes
equation, and would be an ideal alternative, if the specication of the model
were empirically appropriate.
3.5.2 Computing the General Model
Schroder (1989) derives a result that allows easy computation of option prices
for any CEV process. His result would have allowed Beckers, MacBeth and
Merville, Rubinstein and others to easily examine CEV prices other than
those that prior to Schroders result were easy to compute. This work has
been alluded to in Section 3.2.4 where it was used to obtain an expression
for the distribution function of future share prices. The key to that result,
3.5. COMPUTING THE OPTION PRICE 87
and this one, is to note that the integral of interest, in this case Equation
(3.29), can be written in terms of the non-central Chi-squared cumulative
distribution function.
Theorem 3.8. The CEV option price may be written
C
t
= S
t


y
2 p(2z; 2 +
2
2
, 2x)dz Ke
r


y
2 p(2x; 2 +
2
2
, 2z)dz
where y = kK
2
, and p(y; , ) is the probability density function at y of
a Chi-squared random variable with degrees of freedom and non-centrality
parameter , and x and k are dened in Equation (3.33).
Proof. Recalling Equation (3.32) and noting from the proof to Theorem 3.1
ds = k
1/(2)
1
2
z
1+1/(2)
dz
we obtain a further form for f

S
T
|S
t
(s, )ds:
f

S
T
|S
t
(s, )ds = x
1/(42)
z
1/(42)
e
xz
I 1
2
(2(xz)
1
2
)dz
which we can use to examine the option price:
C
t
= e
r
E

((S
T
K)
+
|S
t
)
= e
r


K
(s K)f

S
T
|S
t
(s, )ds
= e
r


z=kK
2

z
k
1
2
K

x
1/(42)
z
1/(42)
e
xz
I 1
2
(2(xz)
1
2
)dz
= S
t


y
e
xz
(z/x)
1/(42)
I
1/(2)
(2

xz)dz
Ke
r


y
e
xz
(x/z)
1/(42)
I
1/(2)
(2

xz)dz (3.40)
since:
e
r
(x/k)
1/(2)
= e
r

S
2
t
e
r(2)

1/(2)
= S
t
.
Schroder recognises that the integrands are both non-central Chi-squared
density functions, of the form given by Johnson et al. (1995) seen in Result
3.3. Recall the form for p(y; , ) given in Equation (3.23):
p(y; , ) =
1
2
(y/)
1
4
(2)
exp

1
2
( +y)

I1
2
(2)
(

y).
88 CHAPTER 3. THE CEV MODEL
The rst integrand in Equation (3.40) is:
e
xz
(z/x)
1/(42)
I
1/(2)
(2

xz).
Comparison of this with p(y; , ) above suggests that the integrand is almost
a non-central Chi-squared density function with
y = 2z = 2 +
2
2
= 2x
except for the factor
1
2
, which is absent. Hence:
e
xz
(z/x)
1/(42)
I
1/(2)
(2

xz) = 2 p(2z; 2 +
2
2
, 2x). (3.41)
The second integrand in the expression for C
t
above is:
e
xz
(x/z)
1/(42)
I
1/(2)
(2

xz).
Again comparison with p(y; , ) indicates that the integrand is almost a
non-central Chi-squared density function with
y = 2x = 2 +
2
2
= 2z
except for the scale factor
1
2
. Hence:
e
xz
(x/z)
1/(42)
I
1/(2)
(2

xz) = 2 p(2z; 2 +
2
2
, 2x). (3.42)
Combining Equations (3.41) and (3.42) yields the desired result:
C
t
= S
t


y
2 p(2z; 2 +
2
2
, 2x)dz Ke
r


y
2 p(2x; 2 +
2
2
, 2z)dz
(3.43)
Note that as written, neither of the integrals in Equation (3.43) are non-
central Chi-squared survivor functions at y. The rst integral has integration
with respect to z rather than the required 2z, whilst the second has integra-
tion with respect to half the non-centrality parameter 2z. Before proving
Schroders result, it is necessary to consider the following result.
3.5. COMPUTING THE OPTION PRICE 89
Result 3.4.


y
2 p(2x; 2 + 2, 2z)dz = 1


x
2 p(2z; 2, 2y)dz
where p(y; , ) is the probability density function at y of a non-central Chi-
squared random variable with degrees of freedom and non-centrality param-
eter .
Proof. A proof of this result can be found in Appendix B.3.
Theorem 3.9 (Schroders Option Pricing Formula). The form of the
CEV option price given by Schroder (1989) is:
C
t
= S
t
Q(2y; 2 +
2
2
, 2x) Ke
r
(1 Q(2x;
2
2
, 2y)).
where y = kK
2
, x and k are given in Equation (3.33), and Q(y; , ) is the
survivor function at y for a non-central Chi-squared random variable with
degrees of freedom and non-centrality parameter .
Proof. The proof of this result follows directly from Theorem 3.8 and Result
3.4. Note the form of C
t
given by Equation (3.43):
C
t
= S
t


y
2 p(2z; 2 +
2
2
, 2x)dz Ke
r


y
2 p(2x; 2 +
2
2
, 2z)dz.
Making the substitution w = 2z in the rst integral yields:


y
2 p(2z; 2 +
2
2
, 2x)dz =


2y
p(w; 2 +
2
2
, 2x)dw
= Q(2y; 2 +
2
2
, 2x).
Similarly, applying Result 3.4 to the second integral and again making the
substitution w = 2z yields:


y
2 p(2x; 2 +
2
2
, 2z)dz = 1


x
2 p(2z;
2
2
, 2y)dz
= 1


2x
p(w;
2
2
, 2y)dw
= 1 Q(2x;
2
2
, 2y).
90 CHAPTER 3. THE CEV MODEL
Hence the option pricing formula is:
C
t
= S
t
Q(2y; 2 +
2
2
, 2x) Ke
r
(1 Q(2x;
2
2
, 2y)) (3.44)
as required.
Recall that Theorem 3.3 gave the form of the cumulative distribution
function for the CEV share price S
T
given S
t
. The proof for the form of this
function in the case s > 0 utilises results now available.
Proof of Theorem 3.3
Proof. We are required to prove the proposition that for s > 0, the cumula-
tive distribution function of S
T
given S
t
is given by the equation:
F
S
T
|S
t
(s, ) = Q(2 x;
2
2
, 2 y)
where

k =
2

2
(2 )(e
(2)
1)
x =

kS
2
t
e
(2)
y =

ks
2
and Q(x; , ) is the survivor function at x of a non-central Chi-squared
variable with degrees of freedom and non-centrality parameter . Note
that from Equation (3.31), the option price at t may be written:
C
t
= e
r
E

(S
T
|S
t
, S
T
> K)P

(S
T
> K|S
t
) Ke
r
P

(S
T
> K|S
t
)
whilst Schroder gives the option price as:
C
t
= S
t
Q(2y; 2 +
2
2
, 2x) Ke
r
(1 Q(2x;
2
2
, 2y)).
Comparing the two formulae it is clear that:
P

(S
T
> K|S
t
) = 1 Q(2x;
2
2
, 2y)
where y = kK
2
, and so replacing r by in x and y, we obtain:
P(S
T
> K|S
t
) = 1 Q(2 x;
2
2
, 2

kK
2
)
3.5. COMPUTING THE OPTION PRICE 91
which yields the desired result:
P(S
T
< s|S
t
) = 1 (1 Q(2 x;
2
2
, 2

ks
2
))
= Q(2 x;
2
2
, 2 y)
where y =

ks
2
.
3.5.3 CEV Option Prices
In the same way that a call price series can be computed for geometric Brow-
nian motion using the Black-Scholes formula, the call price series that cor-
responds to a simulated CEV process can be calculated using Schroders
formula. A dierence is that SPLUS cannot evaluate Schroders formula
when is close to zero, because both the quantile at which the non-central
Chi-squared survivor function must be evaluated, and the non-centrality pa-
rameter become innite. It appears then that both the Q terms will be zero,
yielding an option price of 0, not the same as the required (S
T
K)
+
, however
a limiting argument will undoubtedly yield the correct result. Computation
of Schroders formula becomes increasingly slow as the time to maturity nears
zero (as would computation of the innite sums, since n
2
must be increasingly
large to compensate for growth in k).
Figure 3.7 displays a realisation of {S
t
}, a CEV process with = 1,
S
t
= $5, = 1, = 0.1, = 0.3, and 250 subintervals. In addition, series
corresponding to {C
t
+ Ke
r
} and {Ke
r
} are shown. The dierence be-
tween the two latter curves is of course the option price series {C
t
}. The
graph exhibits the same general qualities shown in the corresponding graphs
for the GBM realisations seen in Figures 2.4 and 2.5. A high degree of cor-
relation is seen between the series {S
t
} and {C
t
}, where every movement
in the share price is mirrored by a movement in the option price. In the
particular realisation in Figure 3.7, the option matures in-the-money, and
so, near exercise when the discounting eect on the exercise price is mini-
mal, the option price plus (discounted) exercise price converges to the share
92 CHAPTER 3. THE CEV MODEL
Time to Maturity - Years
P
r
i
c
e
4
.
0
4
.
5
5
.
0
5
.
5
6
.
0
1.0 0.8 0.6 0.4 0.2 0.0
Share price
Option price + pv(exercise price)
pv(exercise price)
Figure 3.7: A realisation of a CEV share price with initial value S
t
= $5,
and parameters = 1, = 1, = 0.1, = 0.3, and 250 subintervals; also
the CEV option prices for this share series added to the present value of the
exercise price, with K = $5, and r = 0.06 and time to maturity indicated on
the horizontal scale; nally the present value of the exercise price itself.
price, or equivalently, the option price converges to the share price less the
(discounted) exercise price.
Both MacBeth & Merville (1980) and Beckers (1980) have computed and
analysed CEV prices. In particular they compare option prices for various
CEV classes with Black-Scholes option prices. MacBeth and Merville choose
CEV processes with = 0, -2, and -4, aligning the processes to GBM using
the relationship
= S
1

2
t
where is equivalent to the Black-Scholes volatility parameter, as described
earlier.
I have chosen to reproduce part of MacBeth and Mervilles Table 1, using
SPLUS and Schroders pricing formula seen in Equation (3.44). These gures
3.5. COMPUTING THE OPTION PRICE 93
are shown in Table 3.1 and correspond to those of MacBeth and Merville
except in two cases, shown with an asterisk. These values are given as 0.89
and 0.94 by MacBeth and Merville, instead of 0.88 and 0.95 respectively.
The correspondence between the two sets of results indicates that Schroders
formula is indeed reproducing C
t
, correctly and without the need to make
decisions regarding the upper and lower limits of summation in Coxs formula.
The fact that two values dier in the second decimal place, indicates that at
least twice, the values of n
1
and n
2
chosen by MacBeth and Merville have not
ensured convergence of the option price seen in Equation (3.36). In pricing a
large bundle of options, such dierences could amount to signicant pricing
errors.
= 0.2 = 0.4
K = 0 = 2 = 0 = 2
40 1020 1020 1028 1034
30
365
50 127 127 241 241
60 000 000 011 006
40 1062 1064 1130 1158
90
365
50 236 236 431 433
60 006 003

0.95 073
40 1132 1142 1281 1335
180
365
50 355 356 628 634
60 039 028 235 197
40 1205 1221 1415 1489
270
365
50 455 457 785 797
60

0.88 069 365 318
Table 3.1: A section of MacBeth and Mervilles Table 1, of CEV option prices,
calculated for the parameters shown, with additional parameters: S
t
= $50
and r = 0.06.
Beckers compares Square Root and Absolute CEV prices with Black-
Scholes prices. In addition to using Equation (3.36) with n
1
= 0 and n
2
= 995
to obtain the CEV prices, Beckers uses an approximation (attributed to
John Cox, but not referenced) for the Square Root CEV case, and the exact
formula for the Absolute CEV case, given in Equation (3.39).
94 CHAPTER 3. THE CEV MODEL
Earlier, I described the alignment process used by Beckers, to ensure his
CEV prices were comparable to Black-Scholes prices. This involved solving
the equation
Var(S
T
|S
t
) = S
2
t
e
2
(e

2
1)
where the random variable S
T
follows a CEV process with < 2, for [which
features in Var(S
T
|S
t
)], so that all three share price processes considered
have the same variance at T. In contrast, MacBeth and Mervilles alignment
procedure ensured all processes have the same variance over the interval
[t, t +dt].
Using the form for Var(S
T
|S
t
, = 1) given in Theorem 3.2, Beckers shows
that for a Square Root CEV process, is given by the equation:

2
=
S
t
e
+
2

(e

2
1)
e

1
(3.45)
where is the Black-Scholes volatility parameter
7
. I have used this relation-
ship to give the values seen in Table 3.2.
Months to maturity
1 4 7
02 12694 12828 12964
03 19100 19485 19877
04 25579 26439 27331
Table 3.2: Beckers values (rounded to 4 d.p.) for the Square Root CEV
process, found using Equation (3.45), with additional parameters S
t
= $40,
and = log(1.05).
Table 3.3 reproduces a section of Beckers Table II, for the Square Root
CEV case with S
t
= $40 and r = log(1.05). In all but one case, the values
given by Schroders formula correspond exactly to those given by Beckers,
with the single exception when (, K, ) = (0.2, 45,
4
12
), which reads 0.478 in
Beckers table.
3.5. COMPUTING THE OPTION PRICE 95
Months to Maturity
K 1 4 7
30 10122 10495 10908
35 5150 5798 6478
0.2 40 1006 2193 3063
45 0019

0.486 1093
50 0000 0059 0287
30 10123 10639 11307
35 5235 6363 7393
0.3 40 1471 3147 4357
45 0149 1248 2298
50 0004 0393 1082
30 10136 11010 12067
35 5427 7121 8557
0.4 40 1941 4145 5755
45 0397 2156 3670
50 0043 1001 2221
Table 3.3: A section of Beckers Table II, showing Square Root CEV prices,
with additional parameters S
t
= $40, and r = log(1.05).
I have been unable to conrm the Absolute CEV prices given by Beckers,
and have not attempted to conrm the values of he gives in his Appendix
B. These values are obtained by solving the equation:
Var(S
T
|S
t
, = 0) = S
2
t
e
2
(e

2
1)
for , and are reproduced in Table 3.4. These values are of quite a dierent
scale to values given by MacBeth and Mervilles alignment procedure, which
are 8, 12, and 16 corresponding to values 0.2, 0.3, and 0.4 respectively,
indicating the values used by Beckers may have been reported incorrectly.
Note that prices in both Tables 3.1 and 3.3 exhibit the following proper-
ties:
7
MacBeth and Mervilles method yields values of 1.2649, 1.8974, and 2.5398, corre-
sponding to = 0.2, 0.3, and 0.4 respectively. These values are similar to those shown in
Table 3.2, however use of these values, instead of Beckers, results in option prices up to
15% less, with the dierence increasing with time to maturity and .
96 CHAPTER 3. THE CEV MODEL
Months to maturity
1 4 7
02 01769 01818 01868
03 04006 04194 04394
04 07185 07727 08504
Table 3.4: Beckers values (rounded to 4 d.p.) for the Absolute CEV
process, with additional parameters S
t
= $40, and = log(1.05).
As K increases, C
t
decreases;
As increases, C
t
increases;
As increases, C
t
increases.
These general trends, observed for the particular values given above, corre-
spond to the expected behaviour of call option prices as discussed in Chapter
1.
3.5.4 Behaviour of CEV Prices
As mentioned above, CEV prices appear to have similar properties to Black-
Scholes prices, with respect to changes in exercise price, time to maturity, or
the volatility parameter . Of interest is the behaviour of CEV prices when
changes, and in particular whether CEV prices converge to the Black-Scholes
price as nears two. If this convergence were not evident, then this would
indicate a deciency in the CEV option pricing formula.
Coxs formula for CEV option prices, and Schroders method of comput-
ing these prices enable us to examine convergence as nears two from below.
At present we cannot examine convergence from above, however a result de-
rived by Emanuel & MacBeth (1982) completes the CEV class, and gives us
a pricing formula for the case > 2.
Result 3.5 (The CEV Option Price for > 2). In the case > 2, the
risk-neutral transition density function, describing the evolution of the share
3.5. COMPUTING THE OPTION PRICE 97
price S
t
to S
T
is:
f

S
T
|S
t
(s, | > 2) = ( 2)k
1/(2)
(xz
12
)
1
2
1
2
e
xz
I
1/(2)
(2

xz)
where all terms are dened earlier
8
. The option price is given by:
C
t
= S
t
Q(2x;
2
2
, 2y) Ke
r
(1 Q(2y; 2 +
2
2
, 2x)) ( > 2). (3.46)
Proof. A proof of the option price formula can be found in Appendix B.4.
Emanuel and MacBeth cite theoretical support for this model
9
, how-
ever its use obviously conicts with the motivation behind the original CEV
model, including empirical observations regarding share price evolution.
Regardless of the motivation behind each model, any option price over a
share whose price evolves according to Equation (3.1) can now be computed
using Equation (3.44) for < 2, the Black-Scholes formula when = 2,
and Equation (3.46) when > 2. Using these formulae, I have produced the
graphs in Figures 3.9 to 3.11. These gures give call option prices for in the
range 2 6, for various and K, and where S
t
= $50 and r = 0.06.
These graphs give the relationship between C
t
and for out-of-the-money
(K = $55), at-the-money (K = $50), and in-the-money (K = $45) calls as
changes.
Both MacBeth and Merville, and Beckers note the relationship between
call price and . MacBeth and Merville restrict their comments to the pa-
rameter choices they consider, but Beckers makes a more general comment:
As a general rule, it can be inferred that for in-the-money and at-the-money
8
Note that the risk-neutral density that applies in the case > 2 is very similar to that
when < 2, with dierences only in the scale factor (in this case 2 instead of 2 ),
and the degrees of freedom of the modied Bessel function. In fact for = 2, the general
risk-neutral density function could be written:
f

S
T
|S
t
(s, ) = |2 | k
1/(2)
(xz
12
)
1/(42)
e
xz
I
1/|2|
(2

xz)
9
Rubinstein, Mark ((1981),Displaced Diusion Option Pricing, Manuscript, Univer-
sity of California, Berkeley.
98 CHAPTER 3. THE CEV MODEL
options the model price increases as the characteristic exponent [] decreases,
whereas exactly the opposite is true for out-of-the-money options.
10
Whilst
Beckers uses a dierent alignment procedure to MacBeth and Merville, and
I have produced the graphs in Figures 3.9 to 3.11 using the latter authors
alignment procedure, it appears that the relationship Beckers describes does
not hold in general. Even if Beckers comments were restricted to the case
0 < 2, when is very large (perhaps too large given empirical observa-
tions), even in this range C
t
is not a monotonic function of as shown in
the graphs.
A positive aspect of the functions shown in Figures 3.9 to 3.11 is that the
CEV prices appear to converge to the Black-Scholes price, from above and
below, when approaches 2, for the particular combination of parameters
used. This observation lends support to the use of the CEV option pricing
formulae as alternatives to the Black-Scholes formula.
3.6 Use of the CEV Model
In Section 2.5, I noted the volatility smile phenomenon, which provides evi-
dence against the use of the Black-Scholes formula to price share options.
Figure 3.8 shows the Black-Scholes implied volatilities
11
for Absolute CEV
option prices. Parameters used to obtain the CEV option prices were S
t
= $5,
= 1 year, = 0.3, r = 0.06 and $4 K $6. These prices were then used
as market option prices, to yield the Black-Scholes implied volatilities shown
in the graph. In particular I solved the equation:
C
mt
= BS()
for , where the C
mt
are Absolute CEV prices, and BS() is the Black-
Scholes formula treated as a function with a single parameter . The values
of that satisfy the relationship are shown in the graph.
10
Beckers (1980), page 667.
11
The implied volatility is the value of that equates the Black-Scholes model price, to
the observed market price of the option, given other (observable) parameters S
t
, , K and
r.
3.6. USE OF THE CEV MODEL 99
Strike Price
I
m
p
l
i
e
d

V
o
l
a
t
i
l
i
t
y
4.0 4.5 5.0 5.5 6.0
0
.
2
8
0
.
2
9
0
.
3
0
0
.
3
1
0
.
3
2
0
.
3
3
Figure 3.8: Black-Scholes implied volatilities for Absolute CEV option prices
with S
t
= $5, = 1 year, = 0.3, r = 0.06 and $4 K $6.
The curve in Figure 3.8 does not look dissimilar to the implied volatility
curve for options on the S&P 500 index on May 5, 1993, given by Hull
(1997) in his Figure 19.4
12
. Suppose a share price was truly following a CEV
process, and the market was correctly pricing options over that share. Using
the Black-Scholes formula to obtain an estimate for , results in the volatility
smile relationship shown in the graph. The fact that the relationship shown
is similar to those obtained empirically lends indirect support for the use of
the CEV model in practice.
Empirical research already alluded to has endeavoured to determine whether
the CEV model is an appropriate one. In the next Chapter, I attempt to
estimate the coecient for real share price series, but am not able to use op-
tion price information in the analysis. Rubinstein (1985) uses non-parametric
methods to compare option pricing models. Included in the models he con-
12
Hull (1997), page 504.
100 CHAPTER 3. THE CEV MODEL
siders is the Absolute CEV model, whose option price formula is given in
Equation (3.39). In order to identify pricing models consistent with his vast
database of option prices, Rubinstein considers pairs of market option prices
with all characteristics in common except for either the strike price, or the
time to maturity. He then calculates implied volatilities for the pair, and
compares the pattern of relative values to those theoretically observed for
the various models he considers. The Absolute CEV model is consistent
with some of the biases he observes, but like the other models considered, it
does not explain signicantly all the biases observed.
3.6. USE OF THE CEV MODEL 101
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
3
.
8
4
.
0
4
.
2
4
.
4
4
.
6
4
.
8
sigma = 0.4
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
6
.
5
7
.
0
7
.
5
8
.
0
sigma = 0.6
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
9
.
5
1
0
.
0
1
0
.
5
1
1
.
0
sigma = 0.8
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
2
.
0
1
2
.
5
1
3
.
0
1
3
.
5
1
4
.
0
sigma = 1
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
4
.
5
1
5
.
0
1
5
.
5
1
6
.
0
1
6
.
5
sigma = 1.2
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
6
.
5
1
7
.
0
1
7
.
5
1
8
.
0
1
8
.
5
1
9
.
0
sigma = 1.4
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
8
1
9
2
0
2
1
sigma = 1.6
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
2
0
2
1
2
2
2
3
sigma = 1.8
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
2
1
2
2
2
3
2
4
2
5
2
6
sigma = 2
Figure 3.9: Out-of-the-money CEV option prices, with between -2 and 6,
between 0.4 and 2, and additional parameters S
t
= $50, K = $55, = 0.5
years, and r = 0.06.
1
0
2
C
H
A
P
T
E
R
3
.
T
H
E
C
E
V
M
O
D
E
L
b
e
t
a
Call price
-
2
0
2
4
6
6.26 6.28 6.30 6.32 6.34
s
i
g
m
a

=


0
.
4
b
e
t
a
Call price
-
2
0
2
4
6
9.00 9.05 9.10 9.15 9.20 9.25
s
i
g
m
a

=


0
.
6
b
e
t
a
Call price
-
2
0
2
4
6
11.7 11.8 11.9 12.0 12.1
s
i
g
m
a

=


0
.
8
b
e
t
a
Call price
-
2
0
2
4
6
14.3 14.4 14.5 14.6 14.7
s
i
g
m
a

=


1
b
e
t
a
Call price
-
2
0
2
4
6
16.9 17.0 17.1 17.2
s
i
g
m
a

=


1
.
2
b
e
t
a
Call price
-
2
0
2
4
6
19.0 19.2 19.4 19.6
s
i
g
m
a

=


1
.
4
b
e
t
a
Call price
-
2
0
2
4
6
20.6 20.8 21.0 21.2 21.4 21.6 21.8 22.0
s
i
g
m
a

=


1
.
6
b
e
t
a
Call price
-
2
0
2
4
6
22.5 23.0 23.5 24.0
s
i
g
m
a

=


1
.
8
b
e
t
a
Call price
-
2
0
2
4
6
23.5 24.0 24.5 25.0 25.5 26.0 26.5
s
i
g
m
a

=


2
F
i
g
u
r
e
3
.
1
0
:
A
t
-
t
h
e
-
m
o
n
e
y
C
E
V
o
p
t
i
o
n
p
r
i
c
e
s
,
w
i
t
h

b
e
t
w
e
e
n
-
2
a
n
d
6
,

b
e
t
w
e
e
n
0
.
4
a
n
d
2
,
a
n
d
a
d
d
i
t
i
o
n
a
l
p
a
r
a
m
e
t
e
r
s
S
t
=
$
5
0
,
K
=
$
5
0
,

=
0
.
5
y
e
a
r
s
,
a
n
d
r
=
0
.
0
6
.
3.6. USE OF THE CEV MODEL 103
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
8
.
6
8
.
8
9
.
0
9
.
2
9
.
4
9
.
6
sigma = 0.4
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
1
.
0
1
1
.
5
1
2
.
0
1
2
.
5
sigma = 0.6
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
3
.
5
1
4
.
0
1
4
.
5
1
5
.
0
sigma = 0.8
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
5
.
5
1
6
.
0
1
6
.
5
1
7
.
0
1
7
.
5
sigma = 1
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
7
.
5
1
8
.
0
1
8
.
5
1
9
.
0
1
9
.
5
2
0
.
0
sigma = 1.2
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
1
9
.
5
2
0
.
0
2
0
.
5
2
1
.
0
2
1
.
5
2
2
.
0
sigma = 1.4
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
2
1
2
2
2
3
2
4
sigma = 1.6
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
2
3
2
4
2
5
2
6
sigma = 1.8
beta
C
a
l
l

p
r
i
c
e
-2 0 2 4 6
2
4
2
5
2
6
2
7
2
8
sigma = 2
Figure 3.11: In-the-money CEV option prices, with between -2 and 6,
between 0.4 and 2, and additional parameters S
t
= $50, K = $45, = 0.5
years, and r = 0.06.
104 CHAPTER 3. THE CEV MODEL
Chapter 4
Data Analysis
105
106 CHAPTER 4. DATA ANALYSIS
4.1 Introduction
In order to apply the Black-Scholes model to determine option prices on a
stock, a single parameter, , must be estimated. A signicant part of the
empirical literature on option pricing, post Black & Scholes (1972) has tried
to identify the best way to estimate this parameter. These studies have
shown that whilst the Black-Scholes model does not seem appropriate due
to its restrictive set of conditions, the Black-Scholes implied volatility is a
better predictor of future share price volatility than an estimate based on
past and present share prices.
In order to use the CEV model to estimate option prices, not only must
be estimated, but also the CEV parameter . This parameter characterises
the strength of the inverse relationship between share price level, and its
volatility. Estimation of values in real data that were signicantly dierent
from = 2 would lend support to the use of the CEV model for option
pricing, and provide evidence that the Black-Scholes assumptions regarding
share price evolution and its volatility are not satised. In particular, I focus
on the estimation of , with an aim to identify whether or not the CEV
model seems empirically appropriate.
Some empirical papers do use particular CEV models to describe under-
lying asset evolution but do not attempt to chose the best model for their
data, either by implying parameters for option and underlying asset price
data or by direct estimation from the underlying asset series alone. These
papers include Rubinstein (1985), whose work has been discussed in Chap-
ter 3, and Lauterbach & Schultz (1990), who test the Square Root CEV
model against the Black-Scholes and other models for the pricing of war-
rants
1
. Other researchers do endeavour to determine the most appropriate
CEV model, by estimating from time series data. Previously, attempts
1
After adjustment for warrant pricing, this empirical research nds that the Square
Root CEV formula describes observed warrant prices signicantly better than the Black-
Scholes model.
4.1. INTRODUCTION 107
have been made by Beckers (1980), MacBeth & Merville (1980), Emanuel
& MacBeth (1982), Marsh & Rosenfeld (1983), Tucker, Peterson & Scott
(1988) and Melino & Turnbull (1991) to estimate , with varying degrees
of success. Whilst their estimation methods vary, a recurrent theme in the
results is that the CEV model indeed appears to be an appropriate model
for share price evolution. Since modelling the share price has direct implica-
tions on modelling option prices, this nding provides evidence for the use
of the CEV option pricing model in the marketplace. Before introducing the
estimation procedure I have used, I will briey summarise the methodologies
and the ndings of the aforementioned papers.
4.1.1 Summary of Alternative Methods
Beckers (1980)
Beckers estimates values for 47 stocks, using almost ve years data for
each. The SDE (3.1) yields
Var

dS
t
S
t

S
t

=
2
S
2
t
dt.
With daily data, we can set dt = 1, and so rewrite the above relationship in
the form:
ln

S
t+1
S
t

S
t

= ln +
2
2
ln S
t
where s(.) is the standard deviation operator. This is eectively the regres-
sion equation for used by Beckers. Estimation of the regression parameters
will yield estimates for both and . Application of this technique requires
some renement however, as the dependent variable in the regression is not
observable. Using the fact that for daily data is very small, giving
E

S
t+1
S
t

= e

0.
Beckers approximates the standard deviation on the LHS by |ln(S
t+1
/S
t
)|.
This is appropriate if X = ln(S
t+1
/S
t
) is approximately normal, in which
108 CHAPTER 4. DATA ANALYSIS
case, the mean value of X will be proportional to its standard deviation.
This result is proved by Beckers. Thus, using the single realisation of X
instead of the standard deviation of interest, Beckers estimates using the
regression
ln

ln
S
t+1
S
t

= a +b ln S
t
+w
t
(4.1)
where = 2b + 2.
He reports low R
2
and Durbin-Watson statistics which lead him to con-
clude that his regression is incomplete. However, using this technique, Beck-
ers nds that 38 of his 47 cases had estimates signicantly less than two,
with three stocks yielding signicantly greater than two, leaving only six
stocks consistent with GBM. Also, on the basis of his estimates, Beckers nds
evidence to reject the hypothesis that the true values for the stocks are
the same, and concludes that in general, dierent stocks will have dierent
values of , just as their volatilities and other characteristics dier.
Throughout his analysis Beckers restricts the CEV model to : 0 <
2. He concludes that only the 33 estimates in this range support the use of
the CEV model, rather than utilising evidence from all the estimates which
were signicantly above or below two.
MacBeth and Merville (1980)
MacBeth and Merville consider six stocks with options traded on the Chicago
Board of Trade Options Exchange. They use one years daily data to estimate
for each of the stocks. From the SDE (3.1), the Chi-squared random
variable
(dS
t
S
t
dt)
2

2
S

t
dt
u
t

2
1
can be formed given values of and . A sample of daily returns is used to
estimate , and the constant
2
embedded in what they describe as appro-
priate scaling. A sample of values is obtained by choosing a value of , and
4.1. INTRODUCTION 109
this sample tested for goodness of t with a
2
1
random variable, using the
Chi-squared goodness of t test. Using this method, MacBeth and Merville
were unable to nd values that gave consistency between sample values
and the
2
1
distribution, for any of their share series. They attributed this to
non-normality of the dB
t
estimates. Poor estimation of may contribute to
the inability to nd appropriate values however.
In light of this failed attempt, MacBeth and Merville attempt a regression
similar to that of Beckers. The regression equation, found by taking the
natural logarithm of the equation above, is
ln{(dS
t
S
t
dt)
2
)} ln dt = 2 ln + ln S
t
+ ln
2
1
.
This is used to obtain point estimates of , under the assumption that the
(central) Chi-squared random variables are uncorrelated. It is noted that
E(ln
2
1
) = 0, but this should not aect estimates for .
A further regression method is used to obtain condence intervals for ,
using the inverse relationship between and u
t
, the Chi-squared random
variable. The regression methods are said to yield credible but imprecise
estimates for . In fact the condence intervals are large, with only integer
values of considered. MacBeth and Mervilles point and interval estimates
are reproduced in Table 4.1.1. Examination of this shows that only one
condence interval excludes geometric Brownian motion as a model for share
price evolution.
A nal integer estimate for is found by computing implied values
for each stock. To do this they select four option prices on each stock at
random, and for a chosen value of , use a numerical search routine to nd
a value for . This is repeated for other (integer) values until the implied
s are approximately equal. This method yields

s that do lie within the
condence limits in Table 4.1.1, but are very dierent from the previously
obtained point estimates. The estimates are shown in the nal column of the
table.
110 CHAPTER 4. DATA ANALYSIS
Stock Code Condence Limits Point Estimate Implied Estimate
ATT 2 , 6 384 2
AVON 8 , 2 363 0
ETKD 1 , 5 304 0
EXXN 1 , 5 162 0
IBM 8 , 2 416 4
XERX 4 , 2 169 1
Table 4.1: MacBeth and Mervilles estimates for six stocks.
The conclusions drawn from these results are that dierent stocks in gen-
eral have dierent values, and that is in general less than two. In addition,
MacBeth and Merville add that there was evidence in their sample that
changes over time, and that it can be greater than two. The apparent sup-
port for the CEV model provides an explanation for why practitioners who
use the Black-Scholes model to value call options must constantly adjust the
variance rate they input to the model.
2
Comments by Manaster (1980) on the analysis just described appear at
the end of the paper by MacBeth & Merville. These comments focus mainly
on the estimation method of and . Manaster suggests that if and were
estimated jointly, results even more favourable to the [CEV] model could
be achieved. He objects to the daily re-estimation of

and the variance
of returns, since the CEV model has a changing variance built in and re-
estimation of parameters prevents this aspect of the model from being tested.
Emanuel and MacBeth (1982)
This paper examines the data used by MacBeth & Merville (1980) in addition
to a further years data for the same six stocks. Emanuel and MacBeth
employ a method that they themselves admit is not optimal. They use the
relationship
s

dS
t
S
t

S
t

= S
2
2
t
2
MacBeth & Merville (1980), page 299.
4.1. INTRODUCTION 111
to estimate , where the standard deviation on the left hand side is given
by an at-the-money calls implied volatility, found using the Black-Scholes
model. The Black-Scholes implied volatilities are assumed to be reasonable
estimates of share price volatility when calculated using observed at-the-
money option prices
3
even though the Black-Scholes model may not be ap-
propriate in general. In order to nd

, squared dierences between CEV
option prices and selected market option prices
4
are minimised over . Using
this estimation technique, four of the six stocks are found to have estimates
greater than two, lending support to the alternative model that they derive.
Marsh and Rosenfeld (1983)
Marsh and Rosenfelds paper does not model share prices but rather interest
rates, using the CEV model. In order to obtain estimates of for their two
interest rate series, Marsh and Rosenfeld construct a likelihood function for
each series using a modication of the density function given by Cox, seen in
Equation (3.11), with = 1 day. This likelihood function is then calculated
for {0, 1, 2} for dierent values of , where the lognormal density function
is used when = 2. The three dierent likelihood functions corresponding
to the three values of , have maxima at a specic value of . These maxima
are then compared, and the model that gives the largest of these selected.
This in turn species the appropriate estimate of . Using the interest rate
data, of the three models considered, the lognormal ( = 2) model gave the
highest likelihood for each of the time series.
Tucker, Peterson and Scott (1988)
Tucker et al. use the CEV model to describe yet another underlying asset,
foreign currency exchange rates. In order to estimate and for six major
currencies, the log-likelihood function derived by Christie (1982) is used and
3
These observations are documented in Mayhew (1995) and Beckers (1981).
4
Options with less than 90 days to maturity were omitted from Emanuel and MacBeths
sample.
112 CHAPTER 4. DATA ANALYSIS
maximised with respect to and jointly using the Newton-Raphson pro-
cedure. This method is discussed in the following sections, as it is similar to
that which I have used.
Five years data is analysed for the exchange rates (to US dollars) of each
of the six currencies: the British pound, Canadian dollar, Deutsche mark,
French franc, Japanese yen, and the Swiss franc. The data period is split
into ve year-long blocks, and and estimated for each of the ve sub-
periods. They test the null hypothesis H
0
: = 2 against the alternative
H
A
: = 2 for each of the six currencies over each of the ve subintervals,
and nd signicant evidence to reject on 26 of the 30 occasions. In addition
to the support provided for the CEV model, and in particular Emanuel and
MacBeths model, there was evidence to suggest that was changing over
time for the exchange rates.
Melino and Turnbull (1991)
Melino & Turnbull also use the CEV model to describe the evolution of ex-
change rates over time. Spot exchange rate data for ve currencies were
available for a 7
1
2
year period. Like Marsh & Rosenfeld, Melino & Turn-
bull use an adapted form of the CEV density function for the process to
construct a likelihood function. This is evaluated at the restricted range of
= 0,
1
2
, . . . , 2, for a combination of values for the three other unknown
parameters (including ). In addition to this method, they use an approx-
imation like that of Tucker et al. and nd that the maximised value of
the (quasi) log-likelihood were virtually identical to those obtained from the
continuous time model.
5
Once again though, this is only maximised with re-
spect to the other parameters for xed values of . The case of lognormality
was rejected in four out of the ve tests.
5
Melino & Turnbull (1991), page 259.
4.2. ESTIMATING FROM A SHARE PRICE SERIES 113
4.2 Estimating from a share price series
The CEV share price evolves according to the familiar SDE (3.1) reproduced
below:
dS
t
= S
t
dt +S

2
t
dB
t
the solutions to which are given by Cox (1996), Black & Scholes (1973),
and Emanuel & MacBeth (1982) for the cases < 2, = 2, and > 2
respectively. Given a realisation of a such a share price process, the aim of
this section is to obtain estimates of and , for use in option pricing. Recall
that Coxs and Emanuel and MacBeths analyses give us the true transition
density for the solution to the above SDE for the case = 2:
f
S
t+1
|S
t
(s
t+1
, 1) = |2 |

k
1
2
( x z
12
)
1
2
1
2
e
x z
I 1
|2|
(2( x z)
1
2
)
where again:

k =
2

2
(2 )(e
(2)
1)
x =

kS
2
t
e
(2)
z =

ks
2
apply with = 1 day. Theoretically, the likelihood function for a realisa-
tion from this process could be formed, and maximum likelihood techniques
employed to jointly obtain estimates for and ,

and

respectively . Prob-
lems arise not only due to the presence of the modied Bessel function but
also the complicated nature of the density as a function of . In order to
numerically solve a system of equations like
f

,=

= 0
f

,=

= 0
the derivatives, which are likely to be of the form g(, )f(, ) where f(, )
is the density function above treated as a function of and only, and g(, )
is some other function, must be evaluated over a nely divided range of ,
114 CHAPTER 4. DATA ANALYSIS
and for each evaluation, approximation of the modied Bessel function must
be made. Whilst the modied Bessel function appears to converge quickly,
the maximisation process will still be computationally expensive.
In addition, the likelihood function should be evaluated for each of the
three cases: < 2, = 2 and > 2, and the value of

that gives the largest
value chosen.
4.2.1 Estimation Strategy
The estimation method which I introduce in this section uses maximum
likelihood technology, but is an approximate method which is not based on
the true likelihood function for a series of CEV share prices. Using the true
likelihood is possible, but this alternative method is both easier to implement,
and to understand. Although the method is approximate, the estimates
which it gives will hopefully be close to those which would be obtained using
the true likelihood. At the very least, it is hoped that this approximate
method will provide estimates which can be used as starting values in an
estimation process that does use the CEV transitional density.
In order to estimate , I will use the fact that the Brownian motion
increment dB
t
, which appears in the SDE (3.1), is a normal random variable
with zero mean and variance dt. This will allow use of the normal density
function to construct a likelihood function that is simpler than one using the
true transition density for the CEV share price process.
Simplication of the estimation process is made by considering the trans-
formation Y
t
= ln S
t
. Using It os Lemma,
d ln S
t
=


1
2

2
S
2
t

dt +S
2
2
t
dB
t
(4.2)
and so integrating both sides from n to n + 1:
ln S
n+1
ln S
n
=
1
2

n+1
n
S
2
t
dt +

n+1
n
S
2
2
t
dB
t

1
2

2
S
n
2
+S
n
2
2

n
4.2. ESTIMATING FROM A SHARE PRICE SERIES 115
where
n
is a forward N(0, 1) increment that is independent of S
n
(and hence
Y
n
), and it is assumed that the integrands are suciently smooth to allow
the integral approximations to be made, or alternatively, that the time unit
of n is suciently small. Letting n be measured in days, the rates and
must now also be measured in days.
Since Y
n
= ln S
n
, we can write the discrete time equivalent of the SDE
(3.1), and so conditional on Y
n
:
Y
n+1
= Y
n
+(Y
n
) +e
2
2
Y
n

n
(4.3)
N

Y
n
+(Y
n
),
2
e
(2)Y
n

where (Y
n
) =
1
2

2
e
(2)Y
n
is the expected value of the daily returns
Y
n+1
Y
n
, given Y
n
. Thus, an approximate transition density function for
Y
n+1
conditional on Y
n
= y
n
can be written:
f
Y
n+1
|Y
n
(y
n+1
, 1) =
1

2e
2
2
y
n
exp

1
2

y
n+1
y
n
(y
n
)
e
2
2
y
n

(4.4)
and so, for a sample of share prices of size N + 1: S
0
, S
1
, . . . , S
N
, the con-
ditional likelihood for the corresponding series {Y
n
: n = 0, . . . , N} can be
formed. Use of the approximation directly above has an advantage over the
use of the true transition density functions for S
n+1
given S
n
, in that it can be
used for any CEV process. The true likelihood function would be a product
of density functions that have dierent forms for < 2, = 2 and > 2,
and so given an unknown parameter , there might be diculty constructing
the correct likelihood function, especially when is close to two.
Note that:
L(, | s

) = f
Y
0
(y
0
)
N1

n=0
f
Y
n+1
|Y
n
(y
n+1
, 1)
l(, | s

) = ln L(, | s

)
= ln f
Y
0
(y
0
) +
N1

n=0
ln f
Y
n+1
|Y
n
(y
n+1
, 1)
116 CHAPTER 4. DATA ANALYSIS
where L(, | s

) is the likelihood function for the parameters and , given


a realisation, s

, of a share price series. Conditional on the share price sample


s

, in order to maximise the likelihood function L(, ) to nd an estimate


for , it is appropriate to maximise the function
1
N
l(, ) =
1
N
ln f
Y
0
(y
0
) +
1
N
N1

n=0
ln f
Y
n+1
|Y
n
(y
n+1
, 1) (4.5)
which, for large N, is approximately:

l(, ) =
1
N
N1

n=0
ln

2e
2
2
y
n
exp

1
2

y
n+1
y
n
(y
n
)
e
2
2
y
n

=
1
N
N1

n=0

ln
2
2
y
n

1
2
ln 2
1
2

r
n
e
2
2
y
n

= ln
2
2N
N1

n=0
y
n

1
2
ln 2
1
2N
N1

n=0
r
2
n

2
e
(2)y
n
(4.6)
where r
n
= y
n+1
y
n
(y
n
) are realisations of the random variable

R
n
=
Y
n+1
Y
n
(Y
n
).
This log-likelihood function is very similar to that derived by Christie
(1982), and implemented by Tucker et al. (1988), however there are a few
dierences. Christie produces the log-likelihood function:
l(, ) =
N
2
ln(2)
N
2
ln
2

2
2

ln S
1
2
2

r
2
S
S
(2)
(4.7)
where N is sample size, and r
S
=
S
S
is the percentage daily return on the
share price S. In the model above, I am dealing with mean corrected daily
returns, rather than the percentage returns Christie uses. In addition Christie
sees no need for mean-correction, since the parameter is of a much smaller
order than the variance of returns, but by making the log transformation, I
introduce the correction term seen in Equation (4.2). Finally, Christie does
not explicitly take into account the unconditional density function for Y
0
.
The log-likelihood in Equation (4.6) can be constructed from share price
data by rst computing the natural logarithm of the share prices, then taking
4.2. ESTIMATING FROM A SHARE PRICE SERIES 117
the rst dierence of the logs to form a series {r
n
}. Once again I have chosen
to estimate the mean of this series, E(Y
n+1
Y
n
) = (Y
n
), non-parametrically
using the Lowess lter. This estimated mean level can then be subtracted
from the daily returns to give the series { r
n
}, which can be combined with
{y
n
} to calculate l(, ).
Given the equivalence of maximisation of L and

l, as discussed above,
Maximum Likelihood estimates for and could be found by solving the
simultaneous equations:

,=

= 0

,=

= 0.
I do not do this, but rather nd an estimate for

from the second equation
directly above, and substitute this back in to Equation (4.6), which I then
maximise with respect to . This second maximisation is done numerically,
using SPLUS, the details of which follow.
The rst partial derivative of

l(, ) with respect to is:

=
1

+
1
N
N1

n=0
r
2
n

3
e
(2)y
n
. (4.8)
Setting Equation (4.8) equal to zero as described above, and solving for

2
()
yields:

2
() =
1
N
N1

n=0
r
2
n
e
(2)y
n
(4.9)
which may substituted into Equation (4.6). The function obtained by making
this substitution is:

l(,

) =
1
2
ln

1
N
N1

n=0
r
2
n
e
(2)y
n

2
2N
N1

n=0
y
n

1
2
ln 2
1
2
(4.10)
118 CHAPTER 4. DATA ANALYSIS
and maximisation of this with respect to is equivalent to minimisation of
the function:
g() = ln

1
N
N1

n=0
r
2
n
e
(2)y
n

+
2
N
N1

n=0
y
n
(4.11)
obtained from

l(,

) by scaling and removal of additive constants. This


function can be minimised numerically in SPLUS using the function nlmin
as shown in Appendix D.4.
An example of a typical likelihood surface is shown in Figure 4.1, and can
be seen to have a ridge-like surface. This means that the parameters and
are highly interdependent, and that the estimation procedure is probably
not all that well dened for nding

and

jointly. Ideally, the likelihood
surface would have a distinct peak, which would enable the maximisation
process to better pin-point the maximum likelihood estimates

and

. The
scale of
2
in the graph has been altered in the estimation process, by a scale
factor dt. Hence an estimate of
2
is given by

1
dt
S
2
t
where dt is measured in years.
The share price used to construct the log-likelihood surface shown in
Figure 4.1 yields the estimates:

= 0.3176

= 0.02504 = 0.06132.
Choosing to minimise g(), as outlined above, restricts the maximisation
process to a cross-section of the log-likelihood surface, obtained by setting

2
=

2
() as given in Equation (4.9). The log-likelihood function is shown
again in Figure 4.2, along the cross section
2
=

2
(). The vertical line
=

has been superimposed on the graph of

l(,

), and clearly cuts the


curve at its maximum. Hence it appears that the maximisation process is
correctly identifying the maximum likelihood estimate of .
4.2. ESTIMATING FROM A SHARE PRICE SERIES 119
beta
(
s
c
a
l
e
d
)

d
e
l
t
a

s
q
u
a
r
e
d
-0.34 -0.32 -0.30 -0.28
0
.
0
0
0
5
8
0
.
0
0
0
6
0
0
.
0
0
0
6
2
0
.
0
0
0
6
4
0
.
0
0
0
6
6
4.38
4.383
4.384
4.38406
4.384
4.383
4.38
Figure 4.1: The log-likelihood surface,

l(, ), for a simulated series with
S
t
= $5, = 3 years, = 0.1, = 0.3, n = 250 subintervals per year, and
= 0.
beta
l
o
g
-
l
i
k
e
l
i
h
o
o
d
-0.34 -0.32 -0.30 -0.28
4
.
3
8
2
5
4
.
3
8
3
0
4
.
3
8
3
5
4
.
3
8
4
0
Figure 4.2: The cross-section of the log-likelihood surface in Figure 4.1,

l(,

)
for a simulated series with S
t
= $5, = 3 years, = 0.1, = 0.3, n = 250
subintervals per year, and = 0. In addition, the line =

which identies
the maximum.
120 CHAPTER 4. DATA ANALYSIS
4.2.2 The Variance of

Maximum likelihood theory indicates that the estimates of and have de-
sirable asymptotic properties. As sample size increases, they will be unbiased
and normal, with variances obtained via the information matrix:
I(, ) = E


2
l

2
l

2
l

2
l

. (4.12)
Approximating N
1
l by

l as before, and recalling the form of

l(, ) in Equa-
tion (4.6) the partial derivatives can be evaluated and the information matrix
found. The rst partial derivatives of l are:
l

= N

=
1
2
N1

n=0
Y
n
+
1
2
N1

n=0

R
2
n
Y
n

2
e
(2)Y
n
l

= N

=
N

+
N1

n=0

R
2
n

3
e
(2)Y
n
yielding second partial derivatives:

2
l

2
=
1
2
N1

n=0

R
2
n
Y
2
n

2
e
(2)Y
n
=
1
2
N1

n=0

2
n
Y
2
n

2
l

=
N1

n=0

R
2
n
Y
n

3
e
(2)Y
n
=
N1

n=0

2
n
Y
n

2
l

2
=
N

2
3
N1

n=0

R
2
n

4
e
(2)Y
n
=
N

2
3
N1

n=0

2
n

2
4.2. ESTIMATING FROM A SHARE PRICE SERIES 121
where the
n
are approximately N(0, 1), with E(
2
n
) = Var(
n
) = 1. Hence,
by the independence of
n
and Y
n
, elements of the information matrix are:
E

2
l

=
1
2
N1

n=0
E(Y
2
n
)
E


2
l

=
N1

n=0
E(Y
n
)

2
l

=
2N

2
which give the information matrix:
I(, ) =

1
2

E(Y
2
n
)
1

E(Y
n
)

E(Y
n
)
2N

. (4.13)
This has the determinant:
|I(, )| =
2N

2
1
2
N1

n=0
E(Y
2
n
)
(

E(Y
n
))
2

2
=
N

E(Y
2
N
)
1
N

E(Y
N
)

.
The information matrix yields the variances and covariances of the estimates
through the relationship
{I(, )}
1
=

Var(

) Cov(

,

)
Cov(

,

) Var(

These quantities will all feature the terms in the determinant, in particular
E(ln S
n
) and E{(ln S
n
)
2
}, quantities which do not appear easy to calculate
given the density function for S
n
given S
t
, where n > t.
An alternative to calculating the theoretical variance of the estimates of
and is simulation. Share price series with known and can be simu-
lated using the SPLUS function described in Appendix D.3. The likelihood
function can then be constructed for these series, and the maximum likeli-
hood estimates obtained using the method described in Appendix D.4. This
is done in the following section.
122 CHAPTER 4. DATA ANALYSIS
4.3 Appraisal of the Estimation Technique
The estimation of outlined above relies on the assumption

R
n

2
S
2
N(0, 1)
holding at least approximately. The maximum likelihood analysis that fol-
lows this assumption yields estimates for both and . These estimates may
be used to construct a sample which should be approximately unit normal.
The values
e
n
=

R
n

2
S

2
n
(4.14)
can be compared graphically to a unit normal probability density function.
If the two distributions are close, it is possible that the estimate of will
also be good.
This analysis is not as important for simulated series as it is for real
data series, since the simulated series are constructed directly from normal
Brownian motion increments. Examination of the distribution of the quantity
given in Equation (4.14) for selected real series will be done in the following
section. The distribution of the e
n
values for the simulated series, whose
log-likelihood function was examined earlier, is shown in Figure 4.3. This
histogram has the standard normal density function (z) superimposed over
the range of the realised e
n
values. The t seems good, but there is an
outlying value at z = 4.7067. This outlier does not pose a problem however,
and a Chi-squared goodness of t test for the sample yields a very small
test statistic, with a p-value of 96.74% for a test of the hypothesis that the
distribution comes from a standard normal distribution. This is not at all
surprising because of the simulation method for the share series.
If the sample of e
n
values does appear to have a standard normal dis-
tribution, the maximum likelihood procedure should indeed be appropriate.
If so, the estimates should be asymptotically unbiased, and have variances
4.3. APPRAISAL OF THE ESTIMATION TECHNIQUE 123
-4 -2 0 2
0
.
0
0
.
1
0
.
2
0
.
3
0
.
4
R
e
l
a
t
i
v
e

F
r
e
q
u
e
n
c
y
Figure 4.3: e
n
, given by Equation (4.14), for the simulated series examined
previously with S
t
= $5, = 3 years, = 0.1, = 0.3, n = 250 subintervals
per year, and = 0.
obtained via the information matrix. As noted above, the theoretical vari-
ances look dicult to compute, so I have used simulation to estimate the
standard error of estimates of . For given parameter values, it is possible
to generate CEV share series, and then given these series, it is possible to
estimate the parameter . If all parameter values are xed, and the share
price simulation repeated a large number of times, a sample of

values will
form, from which the mean, standard deviation, and approximate distribu-
tion can be estimated. Maximum likelihood theory tells us that for long
series, with N large, the estimate of should be approximately normal, and
so the standardised

values:


s(

)
should be approximately unit normal, where s(

) is an estimate of the stan-


dard deviation of

, given by the sample standard deviation of the

values.
1
2
4
C
H
A
P
T
E
R
4
.
D
A
T
A
A
N
A
L
Y
S
I
S
-
4
-
2
0
2
4
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


-
2
-
6
-
4
-
2
0
2
4
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


-
1
-
4
-
2
0
2
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


0
-
2
0
2
4
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


1
-
4
-
2
0
2
4
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


2
-
4
-
2
0
2
4
6
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


3
-
4
-
2
0
2
4
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


4
-
4
-
2
0
2
4
0.0 0.1 0.2 0.3 0.4
Relative Frequency
b
e
t
a

=


5
-
2
0
2
4
0.0 0.1 0.2 0.3 0.4 0.5
Relative Frequency
b
e
t
a

=


6
F
i
g
u
r
e
4
.
4
:
E
s
t
i
m
a
t
e
s
o
f

,
r
e
s
u
l
t
i
n
g
f
r
o
m
C
E
V
s
h
a
r
e
p
r
i
c
e
s
i
m
u
l
a
t
i
o
n
,
u
s
e
d
f
o
r
t
h
e

g
u
r
e
s
i
n
T
a
b
l
e
4
.
2
.
S
u
p
e
r
i
m
p
o
s
e
d
o
n
t
h
e
s
e
a
r
e
t
h
e
d
e
n
s
i
t
y
f
u
n
c
t
i
o
n
o
f
a
n
N
(

,
1
)
r
a
n
d
o
m
v
a
r
i
a
b
l
e
o
v
e
r
t
h
e
r
a
n
g
e
o
f
t
h
e
e
s
t
i
m
a
t
e
s
,
w
h
e
r
e

i
s
t
h
e
s
a
m
p
l
e
a
v
e
r
a
g
e
o
f
t
h
e

e
s
t
i
m
a
t
e
s
.
4.3. APPRAISAL OF THE ESTIMATION TECHNIQUE 125
I have simulated share series for the nine integer values of in the range
2 6, with S
t
= $5, = 0.1, and = 0.3. For each of these
values I have simulated 1000 series 850 days long, and have used the last
750 observations of each series to estimate . This is intended to reduce the
impact of the fact that all share series begin in the same place, if indeed
these initial conditions have an eect, and replicate the conditions under
which will be estimated for the real series. After 100 days, the share price
will be a random variable whose properties have been discussed in Chapter
3. Recalling that the CEV model allows bankruptcy, it is possible that the
1000 share price series will result in fewer than 1000 estimates of . In fact,
given the initial conditions, the expected number of bankruptcies for some
is large, as is reected in the observed numbers. This analysis is meant to
estimate values for series similar to those for the real data examined in the
following section. Since these series are all approximately three years long,
I have estimated using only the complete simulated series. Estimating
from the shorter series, where bankruptcy is observed, should not improve the
estimates, since fewer observations are available than in the full length series,
nor should it aect them, since the bankrupted series contain no information
not theoretically present in complete series. This same simulation procedure
could be used to test any estimation procedure.
Figure 4.4 shows the distribution of the standardised

values obtained
from the simulation. The normal density curves that have been superimposed
are drawn for the range of standardised estimates, and are for normal
variables with mean

, and variance 1, where

is the sample mean of the

values for each case. The normal curves are clearly not a good t to the
histograms. There are many outlying values in the estimates, and many
of the histograms appear to have a sharper peak than the normal density
functions, indicating positive kurtosis
6
.
The poor t is conrmed by Chi-squared goodness of t tests, with both
the mean and standard deviation estimated from the data, where the null
6
Kurtosis is proportional to the fourth central moment of a random variable X, and is
126 CHAPTER 4. DATA ANALYSIS
hypothesis that the sample values are normal is rejected in every case, with
very high signicance. Note also that many of the normal density functions
are not centred on zero. The biasedness of the estimates is examined in a
table which follows.
Further results of the simulation are shown in Table 4.2. The true
value, used for simulating the share price series, is given, with the sample
mean and standard deviation of the

values,

and s(

) respectively, and
the number of series that did not result in bankruptcy, n.


s(

) n
-2 20265 04308 909
-1 10259 04260 931
0 00154 03925 975
1 10189 03799 1000
2 20218 03850 1000
3 30458 03896 1000
4 40598 04200 994
5 50948 04539 984
6 61384 04922 960
Table 4.2: Summary of the estimates for simulated series, obtained using
the maximum likelihood procedure described above, with S
t
= $5, = 0.1,
= 0.3 and where 3 years data is used.
Comparison of the

and values in Table 4.2 appears to indicate that
the estimates are biased. The normal density curves superimposed on the

distributions were in fact centred on the respective



values, which
appear to dier from zero. For each of the above values of it is possible to
given by
E{(X )
4
}

4
3
where = E(X) and
2
= Var(X). The kurtosis is zero for a normal random variable,
and so positive (negative) values indicate that a density is more (less) peaked around its
centre than a normal density function.
4.3. APPRAISAL OF THE ESTIMATION TECHNIQUE 127
test the hypotheses:
H
0
: = i
H
A
: = i
where i = 2, 1, . . . 6. The Central Limit Theorem provides the result:


s(

n
N(0, 1).
Testing these hypotheses for the nine cases of results in the test statistics
and p-values seen in Table 4.3. The data in the table shows that there is
True Test statistic p-value
-2 18512 00641
-1 18555 00635
0 12220 02217
1 15718 01160
2 17872 00739
3 37171 00002
4 44919 0
5 65487 0
6 87152 0
Table 4.3: p-values for hypothesis test H
0
: = i, i = 2, 1, . . . , 6 using
the simulated data summarised in Table 4.2.
a signicant bias present in the estimation procedure when > 2. The
estimates for Coxs CEV class have an average which is not signicantly
dierent from the true at the 5% level, but at a higher signicance level,
the dierences will become statistically signicant. The gures in Table
4.3 do indicate that the method of estimating is failing for some CEV
processes, and in particular estimates for that are greater than two may
need adjustment to reect this bias.
The sample standard deviation of the estimates is also given in Table
4.2, and these are shown in Figure 4.5. There does not appear to be much
128 CHAPTER 4. DATA ANALYSIS
beta
e
s
t
i
m
a
t
e
d

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n

o
f

b
e
t
a

e
s
t
i
m
a
t
e
s
-2 0 2 4 6
0
.
3
8
0
.
4
0
0
.
4
2
0
.
4
4
0
.
4
6
0
.
4
8
Figure 4.5: Estimates of s(

), the standard deviation of



, from Table 4.2
against the true .
variation in this quantity, but in general it increases as deviates from 2,
particularly for > 2. Both the bias noted for this latter case and the large
standard deviation do not appear to be due to a preponderance of large val-
ues, with the histograms in Figure 4.4 showing symmetry in the

values. In
the following section, where I estimate for 44 stocks, condence intervals
are formed for the true (given that the model is appropriate and there re-
ally is a true ) using the standard deviations of

listed in Table 4.2. This is
an alternative to deriving the theoretical standard deviation using the infor-
mation matrix, and estimating it for the particular share price series. Linear
interpolation of adjacent standard deviations is used for non-integer esti-
mates of . It certainly appears that the range 0.35-0.50 should be adequate
for the true standard error, which when compared to approximate standard
errors of MacBeth and Merville of between 1.5 and 2.5 (assuming condence
interval width of around four standard errors) is very small. Tucker et al.
4.4. DATA ANALYSIS 129
(1988) also give the standard deviation of estimates. For the range of
considered here, their standard errors are between 0.30 and 2.27. They do
not state how these standard errors are obtained, although they dier for
similar values of

indicating a dependence on the realised time series data.
It is also important that the method is producing sensible estimates.
We know that the variance of daily returns should decrease as share price
increases for < 2, and vice versa for > 2. This should be evident in a
plot of the standard deviation of the daily returns against the share price
level. Such a graph was seen in Figure 3.3 for a simulated series, and further
plots will be produced for the real share series in the following section.
4.4 Data Analysis
This section describes an exploratory study of some Australian share price
data, provided by Credit Suisse First Boston NZ Limited. The data set
contains share price, trade, and dividend information for stocks traded on
the Australian Stock Exchange (ASX) which have exchange traded options.
Of this data, there are 44 stocks with full information over the period 2
January 1995 to 17 November 1997. A list of these stocks can be found in
Appendix C. The time period spanned by the data contains a period of
extraordinary turbulence in the world markets, experienced in October 1997.
This period has been omitted from all analysis, as it appears inuences were
exogenous to the Australian market. Thus the data analysed was for a period
2 January 1995 to 26 September 1997. In particular, the analysis focusses
on the estimation of for each of the series, and on the appropriateness of
the technique outlined above.
The estimated values for the 44 dividend corrected share series are
shown in Table 4.4, with estimates of s(

) obtained by linear interpolation


of the function shown in Figure 4.5. Condence intervals are formed using
these standard deviations, with Type indicating what sort of CEV process
130 CHAPTER 4. DATA ANALYSIS
has been estimated. Type 1 corresponds to the CEV class of Cox, with < 2,
Type 2 corresponds to GBM, and Type 3 corresponds to the nal class, with
> 2. The estimates have not been corrected for the biases identied in
the previous section, but this does not have an eect on the classication of
the estimates into the respective Type categories. The bias is signicant
for > 2, however none of the lower condence limits given in Table 4.4
are close enough to two for the bias to have an eect. The closest is that of
ANZ, at 2.2263, which is well above two plus the estimated bias when

3
of 0.0458, given in Table 4.3.
Table 4.4: estimates for the 44 ASX share series, with
estimates of s(

), the standard deviation of



, and the
resulting condence intervals obtained by simulation.
Stock Code

s(

)

2s(

)

+ 2s(

) Type
AAA 08188 03822 00544 15833 0
AMC 22049 03860 14330 29768 1
ANI 12969 03815 05340 20598 1
ANZ 30058 03898 22263 37853 2
BHP 12231 04271 20772 03689 0
BIL 26350 03879 18591 34108 1
BOR 66570 05532 55507 77634 2
BPC 01267 03967 09201 06667 0
BRY 04202 03872 03542 11946 0
CBA 31292 03935 23422 39162 2
CCL 31093 03929 23235 38951 2
CML 39192 04175 30841 47543 2
CSR 63625 05258 53108 74141 2
FBG 23904 03868 16168 31640 1
FXJ 18815 03844 11126 26504 1
GIO 20314 03852 12611 28018 1
GMF 26529 03880 18769 34289 1
ICI 23450 03866 15718 31183 1
LLC 40313 04210 31892 48734 2
MAY 15924 03830 08265 23583 1
MIM 13895 03819 06256 21533 1
NBH 18186 03841 10504 25868 1
continued on following page
4.4. DATA ANALYSIS 131
continued from previous page
Stock Code

s(

)

2s(

)

+ 2s(

) Type
NCM 06649 03841 01034 14331 0
NCP 08809 03814 01180 16437 0
NDY 09427 03807 01814 17040 0
OSH 27619 03885 19849 35389 1
PAS 08373 03820 00734 16013 0
PBL 22324 03861 14602 30046 1
PDP 00709 03948 08606 07188 0
PLU 10940 03804 03331 18548 0
PNI 33607 04005 25596 41618 2
QNI 00424 03919 07415 08262 0
QRL 02894 03888 04883 10670 0
RIO 12305 03811 04683 19928 0
RSG 00053 03924 07795 07901 0
SEV 18940 03845 11250 26630 1
SGB 32647 03976 24694 40599 2
SRP 18503 03843 10817 26189 1
STO 32129 03961 24208 40050 2
TAH 11087 03805 03477 18697 0
WBC 35586 04066 27454 43717 2
WMC 01209 03965 09139 06721 0
WOW 38585 04157 30271 46898 2
WPL 23913 03868 16176 31649 1
The estimates of range from -1.2231 for BHP, to 6.6570 for BOR
7
. The
table clearly shows that there are many stocks in the sample whose share
price does not appear to follow GBM. In fact, at an approximate 95% level,
16 stocks have

signicantly less than 2, and 12 have

signicantly greater
than 2, leaving 16 cases for which GBM cannot be ruled out as a plausible
evolution model.
The estimation of depends on assumptions alluded to in the previous
section, in particular, the quantity e
n
dened in Equation (4.14) is required
to be normal. For each of the share series listed in Table 4.4, I have com-
puted the e
n
values using the share price and daily return data. For each
7
To construct the condence interval for the estimates of BOR and CSR, a further
simulation was run for = 7, with

= 7.1622, s(

) = 0.5850, and n = 924.


132 CHAPTER 4. DATA ANALYSIS
of the stocks, I have tested the hypothesis that the sample of e
n
values has
a standard normal distribution. Using the Chi-squared goodness of t test,
with 27 degrees of freedom, I obtain the p-values shown in Table 4.5.
Stock Code p-value Stock Code p-value
AAA 00040 AMC 00032
ANI 0 ANZ 03701
BHP 02022 BIL 00004
BOR 05043 BPC 0
BRY 0 CBA 01232
CCL 0 CML 00149
CSR 00084 FBG 00001
FXJ 00010 GIO 00002
GMF 0 ICI 00082
LLC 00016 MAY 01913
MIM 01158 NBH 01940
NCM 00003 NCP 00085
NDY 00011 OSH 0
PAS 00011 PBL 0
PDP 0 PLU 00003
PNI 01122 QNI 01590
QRL 0 RIO 01310
RSG 00001 SEV 00005
SGB 00008 SRP 0
STO 00014 TAH 00005
WBC 00070 WMC 05169
WOW 00034 WPL 02363
Table 4.5: p-values for the test of normality of e
n
for the 44 ASX share series,
where e
n
is given by Equation (4.14).
These p-values range from 0 to 0.5169, with 12 being larger than 10%,
indicating that for these shares at least, the estimation approximation may
be appropriate. It is interesting to note that the p-values are either very
small, indicating clear rejection of the hypothesis that the e
n
are normal, or
quite large, where the null hypothesis cannot be rejected at any reasonable
signicance level.
4.4. DATA ANALYSIS 133
Figure 4.6 shows the sample values e
n
for the stock AMC, which has been
randomly selected from the sample of stocks for which the test for normality
was rejected. The p-value for this particular stock was 0.0032, and the graph
helps to show why the null hypothesis of normality was rejected.
The mean and variance of the sample are 0.0106 and 1.0014, which are
very close to the required values of 0 and 1 respectively. The histogram shows
some large positive values, and again, a sharper peak than the normal density
function has (positive kurtosis). Removal of the outliers does not improve the
Chi-squared statistic, indicating that the main problems are in the centre of
the distribution. In particular the shape of the empirical distribution cannot
be well described by a normal probability function.
-4 -2 0 2 4 6
0
.
0
0
.
1
0
.
2
0
.
3
0
.
4
0
.
5
R
e
l
a
t
i
v
e

F
r
e
q
u
e
n
c
y
Figure 4.6: Sample values e
n
, dened in Equation (4.14), for the share price
of AMC, with superimposed N(0, 1) density function.
The share series that do appear to have the desired normality properties
belong to stocks: ANZ, BHP, BOR, CBA, MAY, MIM, NBH, PNI, QNI,
RIO, WMC, and WPL. Of these twelve stocks, four belong to each of the
134 CHAPTER 4. DATA ANALYSIS
three types, with estimates signicantly less than 2, greater than 2, or not
signicantly dierent. Of these I have chosen BHP, BOR, and MIM for
further analysis. Figures 4.7 to 4.9 are of the type seen before, with three
graphs featuring in each. In particular these graphs show the share price
series, the daily return series with an estimated mean level, and a plot of
the estimated standard deviation of the daily returns against the share price
level. This nal graph is intended only to show the general relationship
between share price level and volatility.
As in Figures 3.2 and 3.3, superimposed on the daily returns are estimates
of the mean level, and lines two estimated standard deviations from this
mean. As before, both these averages were determined using the Lowess
lter with a smoothing window of 30 days.
Figure 4.7 gives the graphs for the BHP share price series. BHP has

= 1.2231, and so we should see that the share price is more volatile when
the share price is low, and less volatile when it is high. The share price
series shows a lot of movement in the share price, with periods of increasing
value and decreasing value. The daily returns seem to have a mean that
is oscillating slowly about zero, and a standard deviation that is changing
over time. In the scatterplot, we see that there appears to be a negative
relationship between the share price level and the standard deviation of the
daily returns.
Figure 4.8 gives the same graphs for the MIM share price series. MIM
has

= 1.3895, a value that is not signicantly dierent from 2, and hence
is a process that could be GBM. The share price series appears similar to
that of BHP, with periods of increase and decrease. Once again the daily
returns have a mean level that appears to oscillate about zero, and again have
a changing standard deviation. The dierence between this series and that
of BHP, is that the periods of low volatility do not correspond consistently
to periods of high share price level, nor do the periods of high volatility
correspond to periods of low share price level. This phenomenon is evident
4.4. DATA ANALYSIS 135
by comparing the rst and second graphs for the series, but is best seen in
the third graph. Here, the points seem to be scattered fairly randomly about
the graph, with nothing to suggest an increasing or decreasing relationship,
consistent with the estimation of not signicantly dierent from two.
The nal Figure 4.9 shows the three graphs for the BOR time series.
BOR has

= 6.6570 which indicates that periods of high volatility should
correspond to high share price level, and that periods of low volatility should
correspond to periods of low share price level. The share series in the rst
graph does not show the same oscillation as the other two series, but has a
period of oscillation to begin with, and then a period of growth in the latter
part of the series. Yet again, the daily returns have a mean that appears
to oscillate about zero, and a changing standard deviation. The standard
deviation of the daily returns is highest at the end of the series, consistent
with the size of

, since this is where the share price is largest. Lower
volatility is seen at other times. The third graph indicates that there is a
positive relationship between share price level and the standard deviation of
the daily returns. This and the relationship seen for the other two series,
is probably not linear though, as the specication of the CEV model would
suggest.
The three share series BHP, MIM and BOR have properties that are con-
sistent with the

values estimated from them. In addition, the assumptions
of the estimation procedure, in particular normality of the e
n
are satised for
these series. Thus, it appears that the estimation procedure is giving sensible
estimates for these series at least.
Further analysis of the ASX share data examined above could focus on
the following issues:
Can the estimation procedure be rened to:
incorporate the CEV density function and thus construct the exact
likelihood function for a CEV process;
136 CHAPTER 4. DATA ANALYSIS
identify the source of bias, and either eliminate it, or correct for
it;
determine the asymptotic properties of the estimates?
Does

change signicantly over the length of the series?
Using the estimates of and , does the CEV model adequately de-
scribe market option prices?
Does the CEV model provide better forecasts of future share prices
than alternative models?
Can implied estimates of and be obtained from market option and
share prices, in such a way that forecasts of future share price are
improved?
4.4. DATA ANALYSIS 137
Time - days
S
h
a
r
e

P
r
i
c
e
0 200 400 600
1
6
1
7
1
8
1
9
2
0
BHP
Time - days
L
o
g
-
r
e
t
u
r
n
s
0 200 400 600
-
0
.
0
3
-
0
.
0
2
-
0
.
0
1
0
.
0
0
.
0
1
0
.
0
2
0
.
0
3



Share Price
L
o
g
-
r
e
t
u
r
n

S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
16 17 18 19 20
0
.
0
0
5
0
.
0
0
6
0
.
0
0
7
0
.
0
0
8
0
.
0
0
9
0
.
0
1
0
Figure 4.7: The BHP share series; in addition, the daily returns for this series
with moving mean, and mean 2 standard deviation series; thirdly, a plot
of the share price level against standard deviation of the daily returns.
138 CHAPTER 4. DATA ANALYSIS
Time - days
S
h
a
r
e

P
r
i
c
e
0 200 400 600
1
.
4
1
.
6
1
.
8
2
.
0
2
.
2
MIM
Time - days
L
o
g
-
r
e
t
u
r
n
s
0 200 400 600
-
0
.
0
6
-
0
.
0
4
-
0
.
0
2
0
.
0
0
.
0
2
0
.
0
4
0
.
0
6


Share Price
L
o
g
-
r
e
t
u
r
n

S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
1.4 1.6 1.8 2.0
0
.
0
0
8
0
.
0
1
0
0
.
0
1
2
0
.
0
1
4
0
.
0
1
6
Figure 4.8: The MIM share series; in addition, the daily returns for this series
with moving mean, and mean 2 standard deviation series; thirdly, a plot
of the share price level against standard deviation of the daily returns.
4.4. DATA ANALYSIS 139
Time - days
S
h
a
r
e

P
r
i
c
e
0 200 400 600
3
.
0
3
.
2
3
.
4
3
.
6
3
.
8
4
.
0
4
.
2
4
.
4
BOR
Time - days
L
o
g
-
r
e
t
u
r
n
s
0 200 400 600
-
0
.
0
6
-
0
.
0
4
-
0
.
0
2
0
.
0
0
.
0
2
0
.
0
4


Share Price
L
o
g
-
r
e
t
u
r
n

S
t
a
n
d
a
r
d

D
e
v
i
a
t
i
o
n
3.0 3.2 3.4 3.6 3.8 4.0 4.2 4.4
0
.
0
0
5
0
.
0
0
6
0
.
0
0
7
0
.
0
0
8
0
.
0
0
9
0
.
0
1
0
0
.
0
1
1
Figure 4.9: The BOR share series; in addition, the daily returns for this
series with moving mean, and mean 2 standard deviation series; thirdly, a
plot of the share price level against standard deviation of the daily returns.
140 CHAPTER 4. DATA ANALYSIS
Chapter 5
Conclusions
141
142 CHAPTER 5. CONCLUSIONS
The CEV model has not been used extensively in the option pricing lit-
erature to describe observed option prices. Reasons for this may be that the
option price solution is not an attractive one, and that there is diculty in
estimating the two parameters and .
In researching this thesis, I have attempted to gain an understanding of
the CEV model, and examine its application to real share series. Further-
more, I have attempted to use this understanding to provide a more detailed
analysis of the model than is found in the journal literature. I have described
some of the statistical properties of CEV model share and option prices, and
for the special case, the GBM and Black-Scholes models.
The estimation of using the method I describe is not altogether satisfac-
tory, since the procedure appears to yield estimates that are biased. However,
it does appear to give estimates that are sensible and conform to empirical
observations. Moreover, share series are found to be consistent with each of
the three CEV classes, corresponding to < 2, = 2, and > 2.
This thesis has raised many questions that remain to be answered, but has
provided a platform for further research. I look forward to working further
on the estimation of , and analysing market option prices using the CEV
model. Specic opportunities for extensions to this analysis are listed at the
end of the previous chapter.
Appendix A
Denitions
Throughout this thesis, I have used the following notation consistently. Shown
below is a brief description of the symbol, and a page reference to an appro-
priate denition. Other symbols used in the body of this document are
redened where used.
Symbol Description Page
The CEV parameter; 48

an estimate of the CEV parameter ; 113

the sample mean of n estimates of ; 125


B
t
the value of Brownian motion at time t; 11
C
t
the value of a European call option (exercisable at T)
at t;
3
CEV parameter; 48

an estimate of the CEV parameter ; 113


dB
t
Brownian motion increment over the period [t, t +dt]; 7
dS
t
share price increment over the period [t, t +dt]; 7
E

(.) expectation under risk-neutrality; 51


(q) the value of the standard normal probability density
function at q;
22
(q) the value of the standard normal cumulative distribu-
tion function at q;
22

2
(x, y; ) the bivariate normal cumulative distribution function; 36
f

(.) a transition density function under risk-neutrality; 81


143
144 APPENDIX A. DEFINITIONS
Symbol Description Page
f
X
t+s
|Y
t
(x, s) the (transition) density function for the random vari-
able X
t+s
given the value of another random variable
Y
t
, evaluated at x, and with time interval s elapsed
since t;
g(x, ) the gamma probability density function at x with
shape parameter ;
58
G(x, ) the gamma survivor function at x with shape param-
eter ;
58
g
t
a function that appears in the expected value of Black-
Scholes call prices;
23
h
t
a function that appears in the Black-Scholes formula; 30
h

t
a function that appears in the density function of a
future Black-Scholes price;
32

k CEV variable, featuring in the general transition den-


sity function;
55
k risk-neutral CEV variable, with = r; 82
K the exercise price of a European call option; 3
L(

| x

) the likelihood function for unknown parameters


given data x

;
116
l(

| x

) the log-likelihood function for unknown parameters


given data x

;
116
the mean rate of return on a stock; 11
N(,
2
) a normal random variable with mean and variance

2
;
p(x; , ) the density function of a non-central Chi-squared ran-
dom variable, with degrees of freedom, and non-
centrality parameter ;
71
Q(x; , ) the survivor function of a non-central Chi-squared
random variable, with degrees of freedom, and non-
centrality parameter ;
73
r the continuously compounding risk-free rate; 3

2
the variance of the rate of return on a stock following
geometric Brownian motion;
11
S
t
share price at time t; 3
s(X) the standard deviation of the random variable X;
the time until exercise of a European call option, T t; 3
t present time, or the index of a time series;
T the exercise time of a European call option; 3
145
Symbol Description Page
x CEV variable, featuring in the general transition den-
sity function
55
x risk-neutral CEV variable, with = r; 82
z CEV variable, featuring in the general transition den-
sity function;
55
z risk-neutral CEV variable; 82
Z the standard normal random variable, with zero mean,
and unit variance.
11
146 APPENDIX A. DEFINITIONS
Appendix B
Proofs for Selected Results
B.1 Result 2.2
Let the share price S
t
be the solution to the SDE:
dS
t
= S
t
dt +
t
S
t
dB
t
where
t
is a deterministic function of time. Then the price of a call option
on a stock with share price S
t
must satisfy the PDE:
1
2

2
t
S
2
t

2

C
S
2
+rS
t


C
S
+


C
t
r

C
t
= 0
with boundary condition

C
T
= (S
t
K)
+
, and the call price

C
t
is given by
Black-Scholes equation, with the substitution:

2
=
2

T
t

2
u
du.
Proof. The form of the PDE follows from Equation (2.18), with (S
t
, t) =
t
.
The Black-Scholes function, with

2
=
2

T
t

2
u
du (B.1)
can be written:

C
t
= C(S
t
, , )
147
148 APPENDIX B. PROOFS FOR SELECTED RESULTS
and this will satisfy the PDE:
1
2

2
t
S
2
t

2

C
S
2
+rS
t


C
S
+


C
t
r

C
t
= 0. (B.2)
These partial derivatives are given by:


C
S
=
C
S

2

C
S
2
=

2
C
S
2

=
(B.3)
and


C
t
=
C
t

=
+
C


t

=
where is given by Equation (B.1). Now
C

= S
t
(h
t
)

=
= S
2
t

2
C
S
2

=
since

2
C
S
2
=
(h
t
)
S

. In addition:

t
=
1
2

T
t

2
u
du
T t

=

2

2
t
2
yielding


C
t
=
C
t

=
+
1
2
(
2

2
t
)S
2
t

2
C
S
2

=
(B.4)
and so substituting the partial derivatives given in Equations (B.3) and (B.4)
into the PDE (B.2) gives:
LHS =
1
2

2
t
S
2
t

2

C
S
2
+rS
t


C
S
+


C
t
r

C
t
=
1
2

2
t
S
2
t

2
C
S
2
+rS
t
C
S
+
C
t
+
1
2
(
2

2
t
)S
2
t

2
C
S
2
rC
t

=
=
1
2

2
S
2
t

2
C
S
2
+rS
t
C
S
+
C
t
rC
t

=
= 0
by Equation (2.19) as required.
B.2. RESULT 3.2 149
B.2 Result 3.2
G(y, 1) = 1

n=0
g(y, n +)
where G(y, ) and g(y, ) are the survivor and probability density functions
at y for a gamma random variable with shape parameter and unit scale
parameter.
Proof. Using techniques employed by Schroder (1989), the gamma survivor
function G(y, ) may be written in terms of a recurrence relation, found using
integration by parts:
G(y, ) =


y
g(x, )dx
=


y
e
x
x
1
()
dx
=
e
x
x
1
()

y
+


y
e
x
( 1)x
2
( 1)( 1)
dx
=
e
y
y
1
()
+


y
e
x
x
2
( 1)
dx
= g(y, ) +G(y, 1). (B.5)
Applying this relationship n + 1 times to G(y, n +), we obtain:
G(y, n +) = g(y, n +) +G(y, n 1 +)
= g(y, n +) +g(y, n 1 +) +G(y, n 2 +)
.
.
.
=
n

k=0
g(y, k +) +G(y, 1). (B.6)
Hence, letting n , we obtain:

n=0
g(y, n +) +G(y, 1) = lim
n
G(y, n +)
= 1 lim
n
P(Y
n+
< y)
= 1 (B.7)
150 APPENDIX B. PROOFS FOR SELECTED RESULTS
where Y
n+
is a gamma random variable with parameter n+, and the result
follows.
B.3 Result 3.4


y
2 p(2x; 2 + 2, 2)d = 1


x
2 p(2z; 2, 2y)dz
where p(y; , ) and Q(y; , ) are the probability density and survivor func-
tions at y for a non-central Chi-squared random variable with degrees of
freedom and non-centrality parameter .
Proof. This proof follows the method of Schroder (1989). Note rstly that
there are two alternative formulae for call price C
t
given in Equation (3.34):
C
t
= S
t

n=0
e
x
x
n
G

kK
2
, n + 1 +
1
2

(n + 1)
Ke
r

n=0
e
x
x
n+
1
2
G

kK
2
, n + 1

(n + 1 +
1
2
)
and Equation (3.43)
C
t
= S
t


y
2 p(2z; 2 +
2
2
, 2x)dz Ke
r


y
2 p(2x; 2 +
2
2
, 2z)dz.
These equations allow us to note directly that:


y
2 p(2z; 2 +
2
2
, 2x)dz =

n=0
g(x, n + 1)G(y, n + 1 +
1
2
) (B.8)


y
2 p(2x; 2 +
2
2
, 2z)dz =

n=0
g(x, n + 1 +
1
2
)G(y, n + 1). (B.9)
A result from the proof in Appendix B.2 is:
G(y, n + 1) =
n

i=0
g(y, i + 1) =
n

i=1
g(y, i) (B.10)
which follows since G(y, 1) = g(y, 1).
B.3. RESULT 3.4 151
Letting = 1 +
1
2
, Equation (B.8) yields:


x
2 p(2z; 2, 2y)dz =

n=0
g(y, n + 1)G(x, n +)
and so developing the right hand side of this expression:
RHS =

n=0
g(y, n + 1)G(x, n +)
=

n=0
g(y, n + 1)

G(x, 1) +
n

k=0
g(x, k +)

n=0
g(y, n + 1)

k=n+1
g(x, k +)

where the last two equalities follow from Equations (B.6) and (B.7) respec-
tively. Noting that:

i=1
g(y, i) =

i=0
e
y
y
i
(i + 1)
= e
y

i=0
y
i
i!
= e
y
e
y
= 1
we can expand the nal equation above, and change the order of summation
to yield:


x
2 p(2z; 2, 2y)dz = 1

n=0

k=n+1
g(y, n + 1) g(x, k +)
= 1

k=1
k1

n=0
g(y, n + 1) g(x, k +)
= 1

k=0
g(x, k + + 1)
k

n=1
g(y, n)
Now noting Equation (B.10), the summation in the nal equation can be
written:

k=0
g(x, k + + 1)
k

n=1
g(y, n) =

k=0
g(x, k + + 1)G(y, k +)
=


y
2 p(2x; 2 +
2
2
, 2z)dz
152 APPENDIX B. PROOFS FOR SELECTED RESULTS
by Equation (B.9) and making the substitution =
1
2
. Hence the result


y
2 p(2x; 2 + 2, 2)d = 1


x
2 p(2z; 2, 2y)dz (B.11)
is proved.
B.4 Result 3.5
The option price when > 2 is given by the formula:
C
t
= S
t
Q(2x;
2
2
, 2y) Ke
r
(1 Q(2y; 2 +
2
2
, 2x))
where Q(y; , ) is the survivor function at y, for a non-central Chi-squared
variable with degrees of freedom, and non-centrality parameter .
Proof. This proof follows the derivation of Schroders pricing formula for the
standard CEV case, where < 2. The risk-neutral density function given in
the rst part of this result is:
f

S
T
|S
t
(s, | > 2) = ( 2)k
1/(2)
(xz
12
)
1
2
1
2
e
xz
I
1/(2)
(2

xz).
Emanuel and MacBeth point out that this function has a singularity at s =
and so any integration should be over a range excluding . Hence, they write
the call price at t as the share price at t, less the discounted exercise price,
plus the present value of the amount saved by letting the option lapse when
S
T
< K, which follows since:
S
T
K + (K S
T
)
+
= S
T
K +

0 K < S
T
K S
T
K S
T
= (S
T
K)
+
as required. The present value of the saving (K S
T
)
+
is:
e
r

K
s=0
(K s)f

S
T
|S
t
(s, )ds
B.4. RESULT 3.5 153
and so the option price is given by:
C
t
= S
t
Ke
r
+e
r

K
s=0
(K s)f

S
T
|S
t
(s, )ds.
Note that z is unchanged from its previous denition, and so using
ds = k
1/(2)
1
2
z
1+1/(2)
dz
we can write:
f

S
T
|S
t
(s, )ds = (z/x)

1
2
1
2
e
xz
I 1
2
(2

xz)dz.
Noting that when s = 0 then z = , and when s = K then z = kK
2
= y,
we nd in this case the transformation is a negative one, and so the option
price is:
C
t
= S
t
Ke
r
e
r

z
k
1
2
K

z
x

1/(42)
e
xz
I 1
2
(2

xz)dz.
In the proof of Theorem 3.8, we saw
e
r
(x/k)
1/(2)
= S
t
which leads to yet another representation of the formula for C
t
:
C
t
= S
t


y
e
xz
(x/z)
1/(24)
I
1/(2)
(2

xz)dz

Ke
r


y
e
xz
(z/x)
1/(24)
I
1/(2)
(2

xz)dz

.
The form of the non-central Chi-squared probability density function, p(x; , )
is given in Equation (3.23), and comparison of the above integrands with this
function yields the formula:
C
t
= S
t


y
2 p(2x; 2 +
2
2
, 2z)dz

Ke
r


y
2 p(2z; 2 +
2
2
, 2x)dz

.
154 APPENDIX B. PROOFS FOR SELECTED RESULTS
Using Result 3.4, and making the simple transformations seen in the proof
of Theorem 3.9, yields the option pricing formula given by Schroder:
C
t
= S
t
Q(2x;
2
2
, 2y) Ke
r
(1 Q(2y; 2 +
2
2
, 2x))
as required.
Appendix C
Complete List of Shares
Table C.1: ASX Company Codes
Stock Code Company Name
AAA Acacia Resources Limited
AMC Amcor Limited
ANI Australian National Industries Limited
ANZ Australia & New Zealand Banking Group Limited
BHP The Broken Hill Proprietory Company Limited
BIL Brambles Industries Limited
BOR Boral Limited
BPC Burns, Philp & Company Limited
BRY Brierley Investments Limited
CBA Commonwealth Bank of Australia
CCL Coca-Cola Amatil Limited
CML Coles Myer Limited
CSR CSR Limited
FBG Fosters Brewing Group Limited
FXJ Fairfax (John) Holdings Limited
GIO GIO Australia Holdings Limited
GMF Goodman Fielder Limited
ICI ICI Australia Limited
LLC Lend Lease Corporation Limited
MAY Mayne Nickless Limited
MIM M.I.M. Holdings Limited
NBH North Limited
NCM Newcrest Mining Limited
continued on following page
155
156 APPENDIX C. COMPLETE LIST OF SHARES
continued from previous page
Stock Code Company Name
NCP The News Corporation Limited
NDY Normandy Mining Limited
OSH Oil Search Limited
PAS Pasminco Limited
PBL Publishing & Broadcasting Limited
PDP Pacic Dunlop Limited
PLU Plutonic Resources Limited
PNI Pioneer International Limited
QNI QNI Limited
QRL QCT Resources Limited
RIO Rio Tinto Limited
RSG Resolute Limited
SEV Seven Network Limited
SGB St. George Bank Limited
SRP Southcorp Limited
STO Santos Limited
TAH Tabcorp Holdings Limited
WBC Westpac Banking Corporation
WMC WMC Limited
WOW Woolworths Limited
WPL Woodside Petroleum Limited
Appendix D
SPLUS Code
D.1 GBM Simulation
The following program is an appropriate way of simulating a geometric Brow-
nian motion series in SPLUS. It follows from Equation (2.8), and takes ar-
guments S
t
, , , , and n the number of subintervals in [t, T]. It returns
share with n + 1 elements, which is a realisation of the GBM process over
the time period [t, T].
gbm.f <- function(S,tau,mu,sigma,n){
dt <- tau/n
dB <- rnorm(n,0,sqrt(dt)) (1)
share <- c(S,S*exp(cumsum((mu - 0.5*sigma^2)*dt + sigma*dB)))
(2)
share
}
I have labelled the key parts of the program, and will explain the function
of these.
Line (1) generates n independent N(0, t) random variables, where
t =

n
. These are the realisations of the n Brownian motion incre-
ments needed to construct {S
t
}.
157
158 APPENDIX D. SPLUS CODE
Line (2) computes {S
t
} using the relationship given in Equation (2.8).
A sample of N future prices, all at the smae time T, can be obtained
using the following program. It is an alternative to setting n = 1 in bs.f
above, and repeating N times.
gbm.sample.f <- function(N,S,tau,mu,sigma){
B <- rnorm(N,0,sqrt(tau))
shares <- S*exp((mu - 0.5*sigma^2)*tau + sigma*B)
shares
}
Here, N realisations of an N(0, ) random variable are generated, and are
used to construct S
T
directly.
D.2 Inversion of the Black-Scholes Formula
In order to invert the Black-Scholes formula with respect to any of its ve
arguments a numerical method is required. The Newton-Raphson method is
ideal in this case, since the rst derivative of the Black-Scholes option price
C
t
= S
t
(h
t
) Ke
r
(h
t

)
with respect to S
t
, , K, r and are known.
Result D.1 (The Newton-Raphson Algorithm). The Newton-Raphson
algorithm states that if a is an approximate root of the function f(x), then
a
f(a)
f

(a)
is generally a better approximation.
Let C
mt
be the observed market option price at time t, and let
C
t
= C(S
t
, , K, r, ).
D.2. INVERSION OF THE BLACK-SCHOLES FORMULA 159
The partial derivatives of this function with respect to its arguments can be
shown to be
1
:
C
S
t
= (h
t
)
C

=
S
t
(h
t
)
2

+rKe
r
(h
t

)
C
K
= e
r
(h
t

)
C
r
= Ke
r
(h
t

)
C

= S
t

(h
t
).
These may be used in the Newton-Raphson result to obtain implied parame-
ters of the Black-Scholes function. For example, the value of S that satises
the equation
c = C(S; , K, r, )
where , K, r and are held constant, can be found in SPLUS using the
function bsinvs.f below:
bsinv.f<-function(tau,K,r,sigma,C,a=4,n=100,precision=5e-07)
{
for(i in 1:n){
ht<-(log(a[i]/K)+(r+0.5*sigma^2)*tau)/sqrt(sigma^2*tau)
a[i+1]<-a[i]-(bs.f(a[i],tau,K,r,sigma)-C)/pnorm(ht) (1)
diff<-abs(a[i+1]-a[i])
if(diff<precision)return(a[i+1],i) (2)
}
}
This function has required arguments: , K, r, and C
m
, and optional
arguments: a - the initial guess of S, n - the maximum number of iterations
1
Note that
C
S
,
C

,
C
r
and
C

are always positive, and


C
K
is always negative. This
is consistent with discussion in Chapter 1.
160 APPENDIX D. SPLUS CODE
- and precision - the precision required in the estimate of S, set initially to
510
7
. The estimate of S is returned with the number of iterations needed
for convergence to within the specied (or default) precision. I have labelled
two lines of the program, which have the following function.
Line (1) evaluates the Newton-Raphson result, using an initial esti-
mate for the root, a[i], the Black-Scholes function bs.f, which simply
calculates the Black-Scholes price with parameters S
t
= a[i], = tau,
K = K, r = r, and = sigma, and the rst partial derivative of
the Black-Scholes option price with respect to share price: (h
t
) =
pnorm(ht), to obtain a better approximation to the root a[i+1].
Line (2) returns the estimate of the root if the process has converged
according to the argument precision. In addition, the number of
iterations is returned.
If the process does not converge within n iterations, the program returns an
error message.
D.3 CEV Share Price Simulation
The following program can be used to simulate the solution to the constant
elasticity of variance SDE (3.1). It approximates the solution using the Euler
method as described in Section 3.2.2, and has arguments S
t
, , , =
S
/21
t
, and n the number of subintervals in [t, T]. The share price is
initially set at zero for the length of the series, and then replaced if S
t
i
is
positive. The program returns share with n + 1 elements.
cevS.f<-function(S,tau,mu,sigma,beta,n,dB=rnorm(n,0,sqrt(tau/n)))
{
share <- c(S,rep(0,n))
dS <- NULL
D.4. ESTIMATION OF 161
delta <- sigma*S^(1-beta/2) (1)
for ( i in 1:n ) {
dS <- mu*share[i]+tau/n + delta*share[i]^(beta/2)*dB[i] (2)
if (share+dS>0) {share[i+1] <- share[i]+dS} (3)
else return(share)
}
share
}
This program is fairly similar to that used to generate the GBM price
series, however in this case the share prices are calculated using Equation
(3.19). Specically, the three numbered lines have the following functions.
Line (1) obtains a value of for the given values S
t
, and . This is
equivalent to the alignment procedure of MacBeth & Merville (1980)
discussed in Section 3.2.2.
Line (2) calculates the share price increment dS
t
i
.
Line (3) calculates the share price S
t
i+1
= S
t
i
+dS
t
i
, however if this is
negative the simulation process is stopped and the present and future
values of the series are set equal to zero.
Regardless of bankruptcy, the entire series (of length n + 1) is returned.
D.4 Estimation of
The following program can be used to estimate the value of from a share
series. The function shown in Equation (4.11) is constructed and minimised
for the given share and dividend series.
betaest2.f_function(share,dividends=rep(0,length(share))){
N_length(share)
162 APPENDIX D. SPLUS CODE
share2_share+dividends
r_log(share2[-1])-log(share[-length(share)]) (1)
m_length(r)
ave_lowess(r,f=30/m) (2)
r_r-ave$y
r_r[21:(length(r)-20)] (3)
share_share[21:(length(share)-21)] (4)
assign("share",share,frame=1) (5)
assign("r",r,frame=1) (6)
result_nlmin(function(z){
length(r)*log(mean(r^2/(share^z)))+z*sum(log(share))
},0)[[1]] (7)
list(beta=result+2,share=share,r=r) (8)
}
The function has required argument {S
t
}, a series of closing share prices,
and {d
t
}, the series of dividends paid to holders of the share. The two series
should be aligned so that element i of each series is for the same day. I
have labelled eight lines of the program as follows (1), and will explain the
function of these.
Line (1) constructs the daily returns for the share series, where the
return on day i is given by:
r
i
= ln

S
i
+d
i
S
i1

.
There are m observations in this series where there were N = m + 1
observations in the share series.
Line (2) estimates the mean level (Y
n
) of the log return series, since
E(ln S
n+1
ln S
n
) = (Y
n
) is given by Equation (4.2). The Lowess lter
is used for this purpose with a smoothing window of 30 observations.
D.4. ESTIMATION OF 163
Lines (3) and (4) remove 20 observations from the ends of both the
share price series, and the mean corrected log-returns. In order to es-
timate (Y
n
) at the ends, the Lowess lter estimated observations to
maintain a symmetric 30 observation window. By removing 20 obser-
vations from each end of the series, the eects of this estimation will
not aect the estimation of .
Lines (5) and (6) pass the data share and r to the minimisation
procedure.
Line (7) denes the function which must be minimised, g(), and
orders the minimisation procedure nlmin to return the value of which
minimises g(). It will begin its search at = 2 corresponding to z=0.
Line (8) returns the estimated value for , and the share price and
mean corrected return series.
164 APPENDIX D. SPLUS CODE
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