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    Technical Note 9

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    aamna_shaikh01
    This document describes a general procedure for constructing a trinomial tree to model the behavior of a variable over time. It involves defining nodes at time intervals, the standard deviation and drift of the variable, and calculating probabilities for branches between nodes to match moments and expected values.

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    Technical Note 9

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    aamna_shaikh01
    12 views1 page
    This document describes a general procedure for constructing a trinomial tree to model the behavior of a variable over time. It involves defining nodes at time intervals, the standard deviation and drift of the variable, and calculating probabilities for branches between nodes to match moments and expected values.

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    TechnicalNote9

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    This document describes a general procedure for constructing a trinomial tree to model the behavior of a variable over time. It involves defining nodes at time intervals, the standard deviation and drift of the variable, and calculating probabilities for branches between nodes to match moments and expected values.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    12 views1 page

    Technical Note 9

    Uploaded by

    aamna_shaikh01
    This document describes a general procedure for constructing a trinomial tree to model the behavior of a variable over time. It involves defining nodes at time intervals, the standard deviation and drift of the variable, and calculating probabilities for branches between nodes to match moments and expected values.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
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    Technical Note No.

    9*
    Options, Futures, and Other Derivatives
    John Hull

    Generalized Tree Building Procedure

    This note describes a general procedure for constructing a trinomial tree for a variable,
    x, in the situation where
    1. There are nodes at times t1 , t2 ,...tN where ∆i = ti − ti−1 and t0 = 0
    2. The standard deviation of x between time ti−1 and ti is si
    3. The drift between time ti−1 and ti is mi
    Suppose that x0 is the initial value of x. At time ti the√nodes are chosen to be at
    x0 + jqi where j is a positive or negative integer and qi = si 3∆i . We will refer to the
    node where x = x0 + jqi at time ti as the (i, j) node.
    If we are at the (i, j) node, the expected value of x at time ti+1 is x0 +jqi +mi+1 ∆i+1 .
    Let the node at time ti+1 that is closest to this expected value be the node (i + 1, k) The
    tree is constructed so that we branch from node (i, j) to one of the three nodes (i+1, k −1),
    (i + 1, k) and (i + 1, k + 1).
    We choose the probabilities on the branches to match the first and second moment.
    Define pu , pm , and pd as the probabilities on the upper middle and lower branches. It
    follows that
    pu + pm + pd = 1
    kqi+1 + (pu − pd )qi+1 = jqi + M
    k 2 qi+1
    2 2
    + 2k(pu − pd )qi+1 2
    + (pu + pd )qi+1 = V + (jqi + M )2
    where M = mi+1 ∆i+1 and V = s2i+1 ∆i+1
    The solution to these equations is

    V α2 + α
    pu = 2 +
    2qi+1 2

    V α2 − α
    pd = 2 +
    2qi+1 2
    V
    pm = 1 − 2 − α2
    qi+1
    where
    jqi + M − kqi+1
    α=
    qi+1

    * Copyright
    c John Hull. All Rights Reserved. This note may be reproduced for use in
    conjunction with Options, Futures, and Other Derivatives by John Hull.

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