A note on option pricing for the constant elasticity of variance model (Q1425568)

Consider a securities market model of two assets: a bond and a stock. The stock price dynamics is described by the stochastic differential equation \[ dS_t=\mu S_t dt + \sigma S_t^{\rho} dW_t \] where \(\rho\) is the elasticity of variance. This model, introduced by \textit{J. C. Cox} [J. Portfolio Manag., special issue, 15--17 (1996)] and known as the Constant Elasticity of Variance model (CEV), captures in a simple way the notion that the volatility increases as the asset price decreases. If \(0<\rho <1\), the point \(0\) is an attainable state. Using the properties of squared Bessel processes as the mathematical tool, the authors prove that there exists an equivalent martingale measure for the model that is unique if the appropriate time filtration is considered. As a consequence, for options whose terminal payoff depends only on the stock price process at maturity, they derive the unique no arbitrage price for the option as the discounted expected value under the equivalent martingale measure. The Cox's arbitrage free price for a Call option is just a particular case. Moreover, if the process \(S_t\) is conditioned to be strictly positive then the model admits arbitrage opportunities.