Pricing and Hedging Path-Dependent Options Under the CEV Process

Dmitry Davydov () and Vadim Linetsky ()
Additional contact information
Dmitry Davydov: Equities Quantitative Strategies, UBS Warburg, 677 Washington Boulevard, Stamford, Connecticut 06901
Vadim Linetsky: Department of Industrial Engineering and Management Sciences, McCormick School of Engineering and Applied Sciences, Northwestern University, 2145 Sheridan Road, Evanston, Illinois 60208

Management Science, 2001, vol. 47, issue 7, 949-965

Abstract: Much of the work on path-dependent options assumes that the underlying asset price follows geometric Brownian motion with constant volatility. This paper uses a more general assumption for the asset price process that provides a better fit to the empirical observations. We use the so-called constant elasticity of variance (CEV) diffusion model where the volatility is a function of the underlying asset price. We derive analytical formulae for the prices of important types of path-dependent options under this assumption. We demonstrate that the prices of options, which depend on extrema, such as barrier and lookback options, can be much more sensitive to the specification of the underlying price process than standard call and put options and show that a financial institution that uses the standard geometric Brownian motion assumption is exposed to significant pricing and hedging errors when dealing in path-dependent options.

Keywords: Path-Dependent Options; Barrier Options; Lookback Options; Diffusion Processes; CEV Model; Generalized Bessel Process; Radial Ornstein-Uhlenbeck Process (search for similar items in EconPapers)
Date: 2001
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (109)

Downloads: (external link)
http://dx.doi.org/10.1287/mnsc.47.7.949.9804 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:inm:ormnsc:v:47:y:2001:i:7:p:949-965

Access Statistics for this article

More articles in Management Science from INFORMS Contact information at EDIRC.
Bibliographic data for series maintained by Chris Asher ().