Binomial and trinomial tree methods in derivatives pricing
Abstract
Tree methods for the valuation of financial derivative securities represent a recognized
and well-established pricing paradigm. It has formed part of the financial engineer's
"toolbox" for close on 30 years. The tree approach is multi-dimensional though: there
are for example, various ways in which trees can be parameterized. Incorporating eccentricities
of the financial markets like the paying of discrete dividends and volatility
skews add some further complexity to the approach. A full perspective on the place
of tree methods requires knowledge of the relation between the said and other pricing
paradigms like numerical integration techniques and finite difference methods. Convergence
properties are of definite interest to a practitioner as well. This dissertation
aims to provide a general introduction to tree methods, and well by treating on the
enumerated issues.