Binomial and trinomial tree methods in derivatives pricing

Abstract

Tree methods for the valuation of financial derivative securities represent a recognized and well-established pricing paradigm. It has formed part of the financial engineer's "toolbox" for close on 30 years. The tree approach is multi-dimensional though: there are for example, various ways in which trees can be parameterized. Incorporating eccentricities of the financial markets like the paying of discrete dividends and volatility skews add some further complexity to the approach. A full perspective on the place of tree methods requires knowledge of the relation between the said and other pricing paradigms like numerical integration techniques and finite difference methods. Convergence properties are of definite interest to a practitioner as well. This dissertation aims to provide a general introduction to tree methods, and well by treating on the enumerated issues.