TRINOMIAL TREE APPROXIMATION TO BROWNIAN MOTION

MARK H.A. DAVIS, 25.05.11

1. Random walk model. This is equivalent to a random walk model in which Brownian motion W (t) with variance parameter is approximated for t = , 2, . . . by
k W (k) Xk =

Zj ,
j=1

where Z1 , Z2 , . . . are i.i.d. random variables taking the values h, 0, +h with probabilities p, 1 2p, p respectively. Then EZk = 0, whatever the values of h, p. The idea is to choose h, p so as to match as many moments as possible of the Brownian increment W = (W (k) W ((k 1)) N (0, 2 ). The odd moments are all zero, by symmetry, and the even moments for N (0, ) are m2 = 2 E[(W )2 ] = 2 , 2 4 m4 = 4 E[(W )4 ] = 3 4 2 ,. . . . Now EZk = 2ph2 and EZk = 2ph4 , so for compatibility we require 2ph2 = 2 2ph4 = 3 4 2 , giving p h = =
1 6

3.

We can define a continuous-time process X (t) by

X (t) = Xk

t [k, (k + 1)).

It can be shown that X () converges weakly to W () as 0, i.e. for any bounded continuous function f : Rn R and times t1 , . . . , tn ,
0 lim E[f (Xt1 , . . . , Xtn )] E[f (Wt1 , . . . , Wtn )].

The main advantage of the trinomial model over the binomial model is that it can accommodate time-varying . The idea is this: we fix h = 3 for some average . If the actual variance at step k 2 2 is k then choose p = pk such that 2pk h2 = k , giving pk = 1 6 k
2

. 3 ].

We must have pk [0, 1/2], so the range of possible k is k [0, 2. Exponential model. With Zk as above, we have E[eZk ] =

1 h 2 1 (e + eh ) + = (2 + cosh h). 6 3 3

The exponential asset price model with forward prices Fk is thus

Sk = Fk Mk = Fk exp(Xk k),

where = log( 1 (2 + cosh h)). 3