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arXiv · 1712.03566

Enhancing Binomial and Trinomial Equity Option Pricing Models

Yong Shin Kim·Stoyan Stoyanov·Svetlozar Rachev·Frank J. Fabozzi
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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 It\^o 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 in any node of the trinomial pricing tree.

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Yong Shin Kim, Stoyan Stoyanov, Svetlozar Rachev, Frank J. Fabozzi. 2017-12-10. Enhancing Binomial and Trinomial Equity Option Pricing Models. https://arxiv.org/abs/1712.03566

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