The Convergence of Binomial Trees for Pricing the American Put

24 Pages Posted: 15 Nov 2007 Last revised: 27 Mar 2009

Mark S. Joshi

University of Melbourne - Centre for Actuarial Studies

Date Written: November 14, 2007

Abstract

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.

Keywords: binomial trees, Richardson extrapolation, options, rate of convergence

JEL Classification: G13

Suggested Citation

Joshi, Mark S., The Convergence of Binomial Trees for Pricing the American Put (November 14, 2007). Available at SSRN: https://ssrn.com/abstract=1030143 or http://dx.doi.org/10.2139/ssrn.1030143

Mark Joshi (Contact Author)

University of Melbourne - Centre for Actuarial Studies ( email )

Melbourne, 3010
Australia

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