An Improved Binomial Lattice Method for Multi-Dimensional Options
30 Pages Posted: 12 Sep 2005
Abstract
We propose a binomial lattice approach for valuing options whose payoff depends on multiple state variables following correlated geometric Brownian processes. The proposed approach relies on two main ideas: a transformation of the underlying processes as in the log-transformed binomial lattice approach by Trigeorgis (1991), and a change of basis of the asset span, to transform them into uncorrelated processes. These features improve the efficiency of the multi-dimensional binomial algorithm. We provide a thorough test of efficiency compared to most popular lattice approaches for multi-dimensional diffusions. Although the order of convergence is the same as in the other approaches the proposed approach shows improved efficiency.
Keywords: Option pricing, binomial lattice, multi-dimensional diffusion
JEL Classification: G13
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