A lattice-based model which is used to value options. It extends the structure of the binomial tree, while applying the same core concept. The underlying stock price is conceptualized as a reconverging tree, at each node where the price assumingly follows three paths: up, down, and stable. By multiplying the price at a given node by a specific factor (u, d, m), the three possible values can be figured out.
Then, the resultant values are adjusted to their corresponding probabilities in order to obtain a combined value. As with the binomial trees, the factors and probabilities are set in such a way that the underlying stock prices would evolve as a martingale.
Once the combined value is calculated at each and every node, the option price is computed at each node by working backwards from the future nodes to the most present (initial) one.
Comments