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Technical Note 9

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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35 views1 page

Technical Note 9

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.

Uploaded by

aamna_shaikh01
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

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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