The Convergence of Binomial Trees for Pricing the American Put
Mark S. Joshi
University of Melbourne - Centre for Actuarial Studies
November 14, 2007
We study 20 different implementation methodologies for each of 11 different choices of parameters of binomial trees and investigate the speed of convergence for pricing American put options numerically. We conclude that the most effective methods involve using truncation, Richardson extrapolation and sometimes smoothing. We do not recommend use of a European option as a control. The most effective trees are the Tian third order moment matching tree and a new tree designed to minimize oscillations.
Number of Pages in PDF File: 24
Keywords: binomial trees, Richardson extrapolation, options, rate of convergence
JEL Classification: G13
Date posted: November 15, 2007 ; Last revised: March 27, 2009
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