Pricing Lookback Options Using Binomial Trees: An Evaluation

Abstract

We compare the binomial pricing methods for lookback options developed by Babbs (1992), Hull and White (1993), and Cheuk and Vorst (1994). The Babbs and the Cheuk and Vorst methods are very similar in nature and essentially two applications of the same transformation. The Hull and White method outranks the Babbs and the Cheuk and Vorst methods in terms of flexibility. From a computational point of view, however, both of the latter methods are much more attractive. Our simulation results show that for full lookbacks the prices generated by the Babbs and the Cheuk and Vorst methods are very accurate, even with only a limited number of time steps. Accurate binomial pricing of partial lookbacks appears problematic, however.

JEL Classification: G13