Constant elasticity of variance model

In mathematical finance, the CEV or constant elasticity of variance model is a stochastic volatility model, which attempts to capture stochastic volatility and the leverage effect. The model is widely used by practitioners in the financial industry, especially for modelling equities and commodities. It was developed by John Cox in 1975 In mathematical finance, the CEV or constant elasticity of variance model is a stochastic volatility model, which attempts to capture stochastic volatility and the leverage effect. The model is widely used by practitioners in the financial industry, especially for modelling equities and commodities. It was developed by John Cox in 1975 The CEV model describes a process which evolves according to the following stochastic differential equation: in which S is the spot price, t is time, and μ is a parameter characterising the drift, σ and γ are other parameters, and W is a Brownian motion . The notation 'dX' represents a differential, i.e. an infinitesimally small change in parameter X. The constant parameters σ , γ {displaystyle sigma ,;gamma } satisfy the conditions σ ≥ 0 , γ ≥ 0 {displaystyle sigma geq 0,;gamma geq 0} . The parameter γ {displaystyle gamma } controls the relationship between volatility and price, and is the central feature of the model. When γ < 1 {displaystyle gamma <1} we see the so-called leverage effect, commonly observed in equity markets, where the volatility of a stock increases as its price falls. Conversely, in commodity markets, we often observe γ > 1 {displaystyle gamma >1} , the so-called inverse leverage effect, whereby the volatility of the price of a commodity tends to increase as its price increases.