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Pricing Lookback and Barrier Options under the CEV Process

Published online by Cambridge University Press:  06 April 2009

Phelim P. Boyle and
Yisong “Sam” Tian
Phelim P. Boyle
Affiliation:
Centre for Advanced Studies in Finance, University of Waterloo, Waterloo, Ontario N2L 3G1, Canada
Yisong “Sam” Tian
Affiliation:
Department of Finance, College of Business Administration, University of Cincinnati, Cincinnati, OH 45221
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Abstract

This paper examines the pricing of lookback and barrier options when the underlying asset follows the constant elasticity of variance (CEV) process. We construct a trinomial method to approximate the CEV process and use it to price lookback and barrier options. For look-back options, we find that the technique proposed by Babbs for the lognormal case can be modified to value lookbacks when the asset price follows the CEV process. We demonstrate the accuracy of our approach for different parameter values of the CEV process. We find that the prices of barrier and lookback options for the CEV process deviate significantly from those for the lognormal process. For standard options, the corresponding differences between the CEV and Black-Scholes models are relatively small. Our results show that it is much more important to have the correct model specification for options that depend on extrema than for standard options.

Information

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 34 , Issue 2 , June 1999, pp. 241 - 264
Copyright
Copyright © School of Business Administration, University of Washington 1999

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