Recombining Trinomial Tree for Real Option Valuation with Changing Volatility

25 Pages Posted: 24 Sep 2011 Last revised: 2 Jan 2012

Date Written: April 29, 2010

Abstract

This paper presents a recombining trinomial tree for valuing real options with changing volatility. The trinomial tree presented in this paper is constructed by simultaneously choosing such a parameterization that sets a judicious state space while having sensible transition probabilities between the nodes. The volatility changes are modeled with the changing transition probabilities while the state space of the trinomial tree is regular and has a fixed number of time and underlying asset price levels. The presented trinomial lattice can be extended to follow a displaced diffusion process with changing volatility, allowing also taking into account the level of the underlying asset price. The lattice can also be easily parameterized based on a cash flow simulation, using ordinary least squares regression method for volatility estimation. Therefore, the presented recombining trinomial tree with changing volatility is more flexible and robust for practice use than common lattice models while maintaining their intuitive appeal.

Suggested Citation

Haahtela, Tero J., Recombining Trinomial Tree for Real Option Valuation with Changing Volatility (April 29, 2010). Available at SSRN: https://ssrn.com/abstract=1932411 or http://dx.doi.org/10.2139/ssrn.1932411

Tero J. Haahtela (Contact Author)

Aalto University ( email )

02015 Espoo
Finland

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