Enhancing binomial and trinomial equity option pricing models

Young Shin Kim, Stoyan Stoyanov, Svetlozar Rachev, Frank J. Fabozzi

Research output: Contribution to journalArticle

Abstract

We extend the classical Cox–Ross–Rubinstein binomial model in two ways. We first develop a binomial model with time-dependent parameters that equate all moments of the pricing tree increments with the corresponding moments of the increments of the limiting Itô price process. Second, we introduce a new trinomial model in the natural (historical) world, again fitting all moments of the pricing tree increments to the corresponding geometric Brownian motion. We introduce the risk-neutral trinomial tree and derive a hedging strategy based on an additional perpetual derivative used as a second asset for hedging at any node of the trinomial pricing tree.

Original languageEnglish
Pages (from-to)185-190
Number of pages6
JournalFinance Research Letters
Volume28
DOIs
StatePublished - Mar 2019

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Keywords

  • Cox-Ross-Rubinstein binomial model
  • Itô price process
  • Poisson process
  • geometric Brownian motion
  • trinomial model

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