Predicting the value of foreign currency call options with the Constant Elasticity of Variance diffusion process

This paper examines the ability of the Constant Elasticity of Variance (CEV) model of Cox (1975) to explain observed behavior of foreign currency call option prices. A method using a derivative-free nonlinear regression is developed for jointly estimating the parameters of the class of CEV diffusion processes, and is applied to the valuation of foreign currency call options. The results indicate that the elasticity of variance is nonstationary and significantly less than unity. The CEV model is shown to reduce prediction errors with respect to time to maturity, degree of in-or out-of-the-money, and future volatility of exchange rates.