Generalized Binomial Trees
21 Pages Posted: 9 Sep 1996 Last revised: 20 Nov 2008
Date Written: August 26, 1996
In a novel approach, standard and implied binomial trees are completely specified in terms of two basic inputs: the ending nodal probability distribution and a linear weight function which governs the stochastic process resulting in that distribution. Several key economic principles, such as no interior arbitrage, are intuitively related to these basic inputs. A simple and computationally efficient three-step algorithm, common to all binomial trees, is found. Noting that the currently used linear weight function is unnecessarily restrictive, a binomial tree even more versatile is introduced, the generalized binomial tree. Applications to recovering the stochastic process implied in (European, American, or exotic) options of several times-to-expiration are developed.
JEL Classification: G13
Suggested Citation: Suggested Citation