Binomial Option Pricing Under Stochastic Volatility and Correlated State Variables
Posted: 15 Mar 1995
Date Written: October, 1994
Univariate procedures for valuing contingent payoffs for a non-constant volatility process via a recombining tree were developed by Nelson and Ramaswamy (RFS, 1990). Their results have been extended to the bivariate case for a subset of diffusions by, among others, Kishimoto (JF, 1989), Boyle, Evnine and Gibbs (RFS, 1989), and Hull and White (JFQA,1990). The case of correlated diffusions with constant correlations has also been addressed by Hull and White (JFQA,1990), Amin (JFQA,1991) and Wei(JFEng, 1993). This paper investigates the case where the diffusion volatility includes the state variable from a second diffusion. The direct application of the technology provides a way to price, for example, derivatives based on processes with stochastic volatility via a simple recombining binomial tree with a set of four joint, but possibly non-independent probabilities.
JEL Classification: 521
Suggested Citation: Suggested Citation