You are on page 1of 13

OPTIONPRICINGTREES _

Kaushik Amin
is with L.&man Brothers in New York.

This article provides a selective description of state variables. Monte Carlo methodsor numerical methods
numerical techniquesfor option valuation when the under- for solving partial di@zrential equations are almost com-
lying model is based on certain kinds of dijiision processes. pletely ignored.
It emphasizes models based on discretiring the underlying In the interestof clarity, thefocus is on spec@ pro-
processon a finite state spaceat discretepoints in time and cessesto illustrate the basic principles, forgoing technical
describes techniquesfor building both path-dependent and details that may cloud the basic concepts.The major focus
path-independent discrete-time models that can approxi- is on describing models that can be realistically implemented
mate a given continuous-timeprocessfor the underlying in practice.

I
n most option pricing models, an American
option’s price is basedon the formula: Price = E
[ 1
Payoff (T)
e&j-r(u)du
(2)

Price = Max, E
[ 1
Payoff (t)
,& r(u)du
(1)
where T is the maturity date of the option.
I will take Equations (1) and (2) as given and
not delve into the theory of option valuation. Our
where z is any early exercise strategy (stopping objective is to study methods that can compute the
time);’ E is the expectation over some probability solutions to (1) and (2) when these equations cannot
distribution described by a diffusion process; Payoff be solved in closed form.
(t) is the state-dependent cash flow to the option if it Numerical methods to solve (1) and (2) can be
is exercised at date t; and r(u) is the continuously classifiedinto two types: 1) probabilistic methods, and
compounded spot interest rate at date u. 2) methods that require the numerical solution to
At the terminal date, the option price equals partial differential equations. The probabilistic meth-
the exercise value. The discount factor e6 r(u)du rep- ods compute the solution by constructing an approxi-
resents the time t value of a $1 investment at time 0 mating discrete-time process with discrete states at
that is continuously rolled over at the spot interest each discrete date such that the option value from
rate at each date. It is stochastic in models with this processis an approximate solution to (1) or (2). I
stochastic interest rates and may depend both on the will focus on some of these methods.
time and the state since the spot interest rate may be The solutions to Equations (1) and (2) can also
a function of the state. be written as solutions to an elliptic partial differential
If the option is European, (1) is replaced by equation (hereafter, PDE) with a free-boundary con-
the simpler equation: dition for (1) and a fixed boundary condition for (2).

34 OFTION PRICING TW.E.5 SUMMER 1995


The Feynman-Kac theorem (see Karatzas and Shreve wtth prices [S,, S,]) at any given date. These state
[1988, p. 2671 p rovides this link between PDEs and variables could be the prices of commodities, futures
the solutions to (1) and (2). prices, forward prices, interest rates, and the like. For
An alternative to the techniques discussed in illustration, I assume they are stock prices.
this article is to solve these PDEs numerically. AS Let the evolution of (S,, S2) over time be rep-
there are many cookbook approaches (with corre- resented by the stochastic differential equations:
sponding software packages) to solving PDEs numeri-
cally, this approach may be easier in many cases than
Stock 1: dS,- - p, dt + o1 dW,(t)
implementing the methods studied here. PDEs, how-
Sl
ever, are less intuitive and require much more etyort to
implement if a packaged solution does not exist.
Further, they require that we be able to apply Stock 2 : dS, = p2 dt + <T* dW,(t) (3)
Ito’s lemma to the functional relationship between the s2
option price and the underlying state variables. This
constraint is problematical for certain term structure where ~1, and p2 are the instantaneous expected rates
models (for example, Heath, Jarrow, and Morton of return for S, and S,, which are at most functions of
[1992]) and for many path-dependent options even in time, Q, and or, are their instantaneous volatilities,
the context of very simple models. Finally, when there which are constant, and (W,, W2) is a two-dimen-
are multiple state variables, it is much more difficult to sional Brownian motion with constant correlation p.
incorporate boundary conditions for PDEs than for Equation (3) is the most common method of describ-
probabilistic methods. ing jointly lognormal processes. If S, and S, are stock
There are two classes of probabilistic methods prices, ~1~and pZ will be equal to the spot instanta-
used for computing option prices: 1) Monte Carlo neous interest rate.
methods, and 2) lattice/tree/state space approximation Using Ito’s lemma, (3) can also be written as:
methods. I focus on the second class of methods and
study them under the headings of path-independent Stock 1: cl Log PI (01
and path-dependent models.
A discrete-time model is path-independent if
the state space at any discrete date is composed only of [r-l* - 30; ] dt + B, dW,(t)
the current values of the underlying state variables, i.e.,
the sequence of prior states that lead to the current
state is irrelevant for option pricing.* A path-dependent
Stock 2 : d Log [S*(t)1 =
model is one in which this condition is not satisfied.
CCL2
- ; o;] dt + (TZ dW,(t) (4)
I. PATH-INDEPENDENT MODELS

I first describe the approximation of jointly The increments to the processes due to the dt term
Iognormal (or normal) processes that have constant are hereafter called the drifts of the two processes, and
volatilities and correlation parameters, perhaps the the terms due to the Brownian motions are called the
simplest type of path-independent models. For illus- dispersion terms.
tration, first consider a process with two state vari- From a numerical perspective, it is much easier
ables. As I later show, it is easy to construct models to rewrite the equations in terms of orthogonal
with an arbitrary number of state variables. Brownian motions. Each Brownian motion can be
separately approximated by a simple discrete-time pro-
Model with ‘Iho Lognormal Processes
cess without worrying about the other Brownian
Consider a model with two jointly lognormal motion. Therefore, we redefine (W,, W,) to be
and correlated state variables (say, Stock 1 and Stock 2 orthogonal and rewrite Equation (4) as:

SUMMER 1995 THE JOURNAL OF DERIVATIVES 35


(8) is to construct a discrete-time process whose incre- EWlBIT 1
ments have the same mean and variance-covariance Euw~.m 1 AND 2
matrix over each discrete time interval of width h. In
(8), we can compute the means, variances, and covari- Example 1: Bivariate Distribution over Four States
ante over each time interval ofwidth h as:
State Value of X, Value of X,b Probability
A +1 +1 l/4
E [Log[Vt + WI - LogMO1I = B +1 -1 l/4
C -1 +1 l/4
D -1 -1 l/4

Example 2: Bivariate Distribution over Three States


E[Log[s,(t + hII - Logh(t)1 I =
State Value of X, Value of Xa Probability

[cl2 - +]h A 0 45 l/3


B - d-7-
32 - 4-T
12 l/3
Var [Log [S,(t + h)] - Log [S,(t)] ] = 012 h C 32 l/3
d-7- a-12

Var [Log [S,(t + h)] - Log [S,(t)] ] = 0: h


prices obtained from the discrete-time process will
converge to those for the continuous-time process.
Cov[LogP,(t + WI - Log[WI I,
To illustrate our discrete-time process above,
we provide in Exhibit 1 two examples of the probabil-
ES,@ + 41 -
J-ok? Log [S,(t)] ] = p c+ o2 h (9)
ity distribution for X,(t), )(2(t) at each discrete date.
Using either example, we can build a discrete-
As h + 0, the distribution of the approximat-
time, discrete-state process by which we can compute
ing process will converge to that of the continuous-
option prices recursively using (6) and (7). Because the
time diffusion process in (5). Subject to technical reg-
drift terms [CL, - l/2 c$] h and [p2 - l/2 crg]h are
ularity conditions, for a sequence of discrete-time
deterministic, they do not add to the number of states
processes to converge in distribution to a continuous-
at each date. They can be just added to the random
time difision, there are two main conditions:
increments obtained from (IX,, XJ.
1. The mean, variance, and covariance terms per unit From a computational perspective, the method
time of the discrete sequence of processes must suggested above is particularly simple to implement
converge to that of the continuous-time diffusion. and yields “recombining trees” or a path-independent
2. The limiting process must have continuous sample model. In our context, a model is path-independent if
paths, i.e., as h 4 0, the maximum of the abso- the value of the state variables (S,, SJ at any date
lute increment to the process (jump size) at any depends only on the cumulative values of (X,, XJ up
date must converge to zero. to date t, i.e.,

Equation (9) automatically ensures that condi- l-L-1 --t 1

I
tion (1) is satisfied. Further, from (8), it is apparent
that the discrete-time process cannot have Iarge jumps “c XI (ih), k X2 (ih)
i=O i=O
because increments are of the order d-h . Therefore,
our discrete-time process will converge in distribution
to the desired process in (5). Correspondingly, option Therefore, to compute the value of (S,, S2) at

SUMMER 1995 THE JOURNAL OF D!2RlVWlVES 37


any date t in the future, all we need are these cumula- (labeled as states A, B, C, and D), then the evolution of
tive values. This fact is apparent from (8): the tree for the state variables (S,, S2) over two periods
can be represented as in Exhibit 2. Each node in the
LogP,Wl - L0d%(0)1= tree represents a possible value of (S,, S,) at that date.
Notice that the tree is recombining. That is, an
i=-- t
increment to (S,, S,), labeled as A, followed by an
1
increment labeled C, yields the same state as an incre-
f; [ [p, - : $1 h + O, & X,(ih)] ment of C followed by an increment of A. Also note
IdI L
that both (A, D) and (B, C) produce the same values
t
for S, and S,. This feature by which branches in the
i=--1 i=-- t 1
tree recombine ensures that the number of states at any
= ke[[pl - i$]h] + CJ, & i X,(ih) given date is manageable and that the tree is numerical-
i=O i=l) ly feasible. Without this feature, the number of branch-
es grows exponentially, and we are restricted to using
Log F,(t)1 - Log [S,(O)1 = trees with only a small number of time steps. Further,
such models are more complicated to implement.
t
i=--1 With two variables and four possible incre-
ments (i.e., four points in the distribution of (X1, XJ
at each date), the number of states after N steps is (N
+ l)*. A model with 200 time steps with two state
variables is very easy to implement, and yields suffi-
021 & X,(ih) + (J** & X?(ih)]
ciently accurate prices for almost all practical purpos-
es. The running time for such a model on a Pentium
i=L-1 personal computer is a few seconds.
= 5 [[p2 - ‘o;]h]
2
+ The examples given above and the representa-
i=O tion in (8) are based on Amin [1991]. These examples
differ from the methods described in Cox, Ross, and
i=l-1 i=l-1 Rubinstein [1979] or Boyle, Evnine, and Gibbs
[1989] by separating the drift and variance terms and
(~2~ & 2 X,(ih) + 02? & f: X,(ih)
i=O i=(l
orthogonalizing the Brownian motions in the multi-
variate case. These modifications make the numerical
The drift terms are deterministic, so the value implementation very simple, particularly with multi-
of S,(t), S,(t) is a deterministic function of ple state variables.

Models with an Arbitrary Number


of Correlated Lognormal Processes

At this stage, we can incorporate additional


state variables. M lognormal state variables can be rep-
resented by the system of equations:

In particular, we do not need to know the sequence Log [Sj(t + h)] - Log [Sj(t)] =
(or the path) by which the different values of (Xl, XJ
are realized at each of the prior dates. Therefore, the
model is path-independent. [~j - ~ ~J?] h + ~ in Oji Xi(t)
A simple figure illustrates the notion of path- i=l

independence. Consider example 1. If there are four


possible values that (X,, XJ can take on at each date forj = 1, . . . . M

38 OPTIONPRICINGTREES SUMMER1995
ESHIBIT 2 cross-product of the states due to each dimension.
EVOLUI’IONOFTwo STATEVARIABLES
wm FOUR This state space is numerically feasible for realistic
POSSIBLEINCKEMINCS Two PERIODS problems with up to five state variables and thirty time
ATEACHDA-ITOVE:R
stepsand can be used in practice.

(A) W-4 Path-Independent Models for


Processes that are not Lognormal

(B)
(AB)
What if the volatility function is not lognormal
with a constant volatility? The simple discretizations
(A.0
given above will not yield path-independent models.

63 (AD). UK)
Path-dependent models, however, can be quite use-
ful, as we will show. In some special cases,it is possi-
ble to use additional tricks to make the model path-

e (D) (B.D)
independent.
CASE 1: SINGLE STATE
VOLATILITY FUNCTION A DETERMINISTIC FUNC-
VARIABLE;

TION OF TIME. Suppose the stochastic differential


equation of the underlying state variable is represented
by the equation:

@.D) d LogVW1 = k (4 - ; o,(t)*] dt +

where Xi(t), i = 1, . . .. M are uncorrelated random


variables with mean zero and variance 1. They are 0, (4 dWI,It) (10)
also serially uncorrelated.
Further, if we define d to be the matrix whose In practice, this example is quite important becauseit
(i, j)th element is 0.. above, the parametersC$ need to permits us to capture time variation in the volatility.
be chosen so that bto is equal to the desired instanta- The standarddiscretization studied earlier for this pro-
neous variance-covariance matrix of the state vari- cesswould take the form:
ables. There is no unique way to choose these param-
eters, but a convenient method is to use the Cholesky
decomposition (seePresset al. [1992, p. 961).
Log&(t + Ml - LogP&)1 =
We illustrate a distribution of (X,, T, X,, ...)
with an arbitrary number of variables. Let (X,, &, [PI - ; q(t)*] h f q(t) & x,(t) (11)
X,, ...) be jointly independent. Further, let each ran-
dom variable Xi (for i = 1, 2, 3, ...) have only two
states with (+l and -1) equal probability. Since each a process that is path-dependent. The sequence in
variable adds two possible states, with M state vari- which the values of X,(t) are realized is relevant for
ables, there can be 2M equi-probable increments over determining the value of S,(.) at some future date
each interval from date t to t + h. because the increment of X,(t) is multiplied by a
Example 1 in Exhibit 1 is a special case with time-dependent term o,(t) to obtain the increment to
two state variables. This scheme will yield a total of the log of S,(t).
(N + l)M states after N time steps. Each dimension To eliminate this path-dependence, we choose
represented by the cumulative values of Xi, for i = 1, variable step sizes & so that the product or(t) fi
2, 3, .. . generates (N + 1) states at each date. Since all is constant at each time step. Then, once again the
the Xis are independent, the entire state space is a order of occurrence of the increments X,(.) becomes

SUMMER 1995 THE JOURNAL OF DFAIVATlVE5 39


irrelevant, and we obtain a path-independent model. volatility with multiple variables. Their technique is
Therefore, the analogue of (11) can be written as: more complicated than the one discussedabove.
CASE 2: THE STATE’ SPACE APPROACH. so
far we have tried essentially to build multinomial trees
Log [S,@+ h)l - LogP, (91 = to approximate the distribution of the underlying
continuous-time process.Building a tree is not neces-
sary if we view the process purely as a numerical
[PI - ; cW’1 h, + q(t) fi x,(t)
problem. Then, the only issue is to approximate the
distribution of the increments to the variables in each
and state at each date and apply Equations (6) and (7) to
compute the option price. This distribution can be
LogP,HI - LogMQl = approximated in relatively simple ways.
Suppose the process of interest is represented
by the equation:

dS(t) = l.t (t, S(t)) dt -t 0 (t, S(t)) dW(t) (13)

where nr is the number of time steps up to time t and we are interested in the evolution of S(t) up to
(which now depends on the time variation in the some date T. Discretize the time interval into N peri-
volatility). 6, (i) and hi are the volatility and size of the ods of duration h = T/N. Instead of building a tree,
time step over the ifh interval. fix an arbitrary state space at each discrete date with
The trick used above dependson the concept of points equally spaced in the space dimension where
time change in probability theory Essentially, when the spacing is “sufficiently” close.4 Such a state space
volatility is high, we slow the clock by taking smaller is shown in Exhibit 3 where the state points are equal-
time steps, and when volatility is low, we speedup the ly spacedA units apart.
clock by takmg larger time steps.Under the new clock, At the terminal date of the option, the option
it appearsas if the volatility is constant, and we can use value at each of the points on the grid can be deter-
our earlier methods for approximating the process.But, mined as a function of the state and time. Given the
as is apparent from this analogy,we cannot extend this value of the option at the terminal date, we can
trick easily if there are multiple state variablessince the work backward through time on the state space grid,
time change (variable step size) for one variable may computing the option values by applying Equations
not be the sameasthat for the other statevariables. (6) and (7).
The important feature is that the time change Supposethe option prices for each of the points
is deterministic, i.e., we speed up the clock and slow on the grid at date t + h have already been computed.
it down according to a predetermined scheme. Now, consider the grid at date t. To apply (6) and (7),
Otherwise, at any point in the future, we would not we have to approximate the distribution of the incre-
know how much time had elapsed, and therefore we ments to the processfrom date t to date t + h.
would not be able to discount appropriately (if the Consider a discretization of the continuous-
interest rate is not constant, we would not know what time processgiven by:
rate to use) or know if we are at the maturity date.3
Even though there is a corresponding concept when S(t + h) - S(t) = CL(t, S (t)) h + CF(t, s (t)) &
the volatility can also be a function of the state, imple-
menting a tree-based model of the type discussed probability = 0.5 State A
above is difficult and requires augmenting the state
spaceby an additional state variable. = CL(t,S 6))h - o (t, s (t)) dii
Ho, Stapleton, and Subrahmanyam [1993] have
developed some techniques for time-dependent probability = 0.5 State I3 (14)

40 OPTION PRICING TREES SUMMER 1995


zero when the stock price is zero and is equal to S -
Xe-‘cT*) when the stock price is very high.
In many cases, however, it is possible to con-
struct the state space so that the option price at date 0
does not depend on the values set at the extreme
points on any date. Essentially, we choose the state
8A* space to be sufficiently wide at each date so that start-
ing from the state at date 0, it is not possible to reach
TA. TA*
any of the boundary points except at the final maturity
Even with multiple state variables, we can fol-
6A. 6A. 6A*
low the state space approach. Any discretization that
sA. sA. sA* 5A* matches the mean, variance, and covariance (in the
limit) of the continuous-time process over each time
4A. 4A. 4A* 4A. interval can be used. With multiple state variables, we
need to interpolate in multiple dimensions.
3A* 3A* 3A. 3A* In fact, the state space approach described above
T can be used even when the underlying process is not a .
State 2A0 2Ae 2Ae 2A. diffusion. Essentially, if the distribution of the incre-
merits to the process over finite intervals is known, it is
A. A. A. A. straightforward to approximate this distribution recur-
o* 0. 0. O@ sively over a finite state space grid and compute option
prices by a backward recursion on time.
Tie -b An alternative approach that can be used in
o h 2h 3h cookbook form is due to Kushner [ 19771. This
method is based on writing a specific finite difference
In general, for a given value of S(t) on the grid version of the partial differential equation satisfied by
at date t, the two possible values for S (t + h) for states the option. The resulting formulation has an intuitive
A and B given above may not be in the state space probabilistic interpretation, but it is significantly more
that we have fixed for date t + h. This problem does complicated than the methods studied’here.
not arise for the trees that we constructed earlier, CASE 3: A SINGLE STATE VARIABLE, WITH
because the grid at each date by construction includes VOLATILITY AND DRIFT PERMITTED TO BE
all the possible values that the variable could take on. FUNCTIONS OF THE STATE VARIABLE. A special
We can still interpolate the option values from case of the state space approach is suggested by Nelson
points adjacent to states A and B on the grid to obtain and Ramaswamy 119901. Here, I describe a slightly
the interpolated option value for each of the states A and modified version of that method, which has better
B. This interpolation can take the form of linear or numerical properties than the original. Essentially, we
quadratic interpolation. In fact, we can even approximate transform the process so that the volatility is constant
the increments to the process at more than two points. under the new process.
Once the option values in the relevant states at date t + h Suppose there is a single state variable whose
are known, we can compute the option value at t in the evolution is given by the stochastic dif&-ential equation:
state S(t) by using Equations (6) or (7) and (14).
The final issue relates to the option values at dS = ~.t(t, S(t)) dt f 0 (S(t)) dW(t) (15)
the extreme points (boundary conditions) at each dis-
crete date. Unfortunately, the option values at these Define a function Y(S) such that
extreme points have to be set based on the nature of
the process for S(t) and the type of the option. For Y (S) = j” --I- dx
example, for a caIl on a stock price, the option price is 0 F>

SUMMER 1995 THE JOURNAL OF DERIVATIVES 41


on the state space on which S can take values. We One potential problem with this approach is that
assume that Y(S) is monotonic and twice continuous- q, in Equation (18) may be outside the interval [O, 11.’
ly differentiable in S. Given (15), and the definition of We can solve this problem by‘changing the increments
Y(S), the distribution of the process Y(t, S(t)) is well to Y(t). Choose an integer i such that Y(t) + @., it,
defined using Ito’s lemma: Y(t)) h) is between Y(t) + i & and Y(t) + (i - 2) 4.
Then, if we permit the changes to Y(t) to be of
dY (t, Y(t)) = pLv (t, Y(t)) dt + dW(t) (16) the form:

This process has a constant volatility (equal to Y(t + h) = Y(t) + i &


l), but its drift represented by ~1~ (t, Y(t)) is a function
(that can be determined from Ito’s lemma) of both the or X(t) = i with probability qh E [0, 11
state and time. Also, given the process for Y(t), we can
recover S from Y at each date and for each value of Y Y(t + h) = Y(t) + (i - 2) &
using an inverse transform:
or X(t) = i - 2 with probability 1 - q,, (19)
S(t, y) = (s: Y(t, s) = y) (17)

Therefore, if we can build a computationally feasible where qh = -z i + + (1 + py (t, Y(t)&).


tree for Y(t), using (17) we also obtain a computation- The process obtained through this discretiza-
ally feasible tree for S(t). tion scheme is not a simple binomial tree as in Cox,
We can approximate the distribution of the Ross, and Rubinstein [1979], even though, given a
process Y(t) with the discrete-time process: value for Y(t) at date t, there are only two possible
values at date t + h. The discrete state space at each
Y(t + h) = Y(t) + & with probability
discrete date consists of points that are integer multi-
ples of &, and the process can take on increments of
9& Y(t))
size i & or (i - 2) & where i depends on the state.
= Y(t) - & with probability Unlike the binomial model of Cox, Ross, and
Rubinstein [ 19791, in which the process can move to
1 - q& Y(t)) only adjacent points on this state space grid, the pro-
cess is now permitted to move to non-adjacent points.
where qh(t, Y(t)) is chosen so that the expected Therefore, the state space is not a triangular binomial
change in Y from t to t + h equals the drift (p,( (t, type tree, but is of the type shown in Exhibit 3 with A
Y(t)) h) of Y over h. This condition ensures that set equal to & in the figure.
This process satisfies both the mean and vari-
ance restrictions that are necessary for the discrete-
qh = ;(l + py(t, Y(t) Ji;, time equivalent of Y(t) to converge in distribution to
the continuous-time process. Further, it is also path-
independent in that only the cumulative value of X(.)
In our earlier notation: completely determines the value of Y(t), and corre-
spondingly S(t) through (17). Therefore, the distribu-
Y(t + h) -Y(t) = X(t) JI; tion of the discrete-time equivalent of S(t) also con-
verges to that in (15).
where X(t) has a distribution over +l with probability Given a discrete-time process for Y(t) and
q&k Y(t)) and -1 with probability (1 - qh (t, Y(t))). therefore for S(t), we can compute option prices using
This discretization scheme yields a binomial tree as in a backward recursion.
Cox, Ross, and Rubinstein [ 19791. A significant problem with this approach is that

42 OPTION PRICING TREES SUMMER 1995


it cannot be extended to multiple dimensions (or state scheme for a path-dependent model is described.
variables) in an obvious way However, the state space Consider discrete time steps of width h. Now,
approach studied in case 2 permits almost arbitrary a foonvard rate for maturity T corresponds to borrow-
volatility functions even with multiple state variables. ing or lending money from T to T + h. The evolu-
tion of these forward rates can be represented by the
II. PATH-DEPENDENT MODELS discrete version of (20) by the equation:

Now consider the implementation of path- f(t+h,T)-f(t,T)=


dependent models. These models are almost com-
pletely general and can accommodate arbitrary volatil- a (t, T) h + (T(t, T, .) & X(t) (21)
ity functions. For illustration, I use the one-factor
term structure model of Heath, Jarrow, and Morton where (X(.)) is a sequence of serially uncorrelated ran-
[1992], hereafter HJM. This model is non-Markovian, dom variables with zero mean and unit variance. A
and a standard PDE satisfied by all option prices does sample distribution for X(t) is given in Example 3,
not exist (except in very special cases). Therefore, sample distribution of (X(t)) over two states:
PDE approaches cannot be used.
Let f (t, T) be the forward interest rate at date t Value 0fX Probability State
for borrowing or lending money at date T. HJM +1 0.5 A
model the evolution of all forward rates simultaneous- -1 0.5 B
ly according to the equation:
Given the discretization method (21), the drift func-
df (t, T) = a (t, T) dt + (T(t, T, f (t, T)) dW(t) (20) tions a (t, T) can be computed from the equation:

where c~(t, T, .) is the volatility function depending on


calendar time t, maturity T, and the forward rate f (t,
T); and W(t) is a one-dimensional Brownian motion.
This volatility function constitutes the parameter
input to the model. For the purpose of option pric-
ing, the drift function a (t, T) is determined within
the model to preclude arbitrage.
Note that all forward rates of all maturities are
simultaneously driven by the same stochastic differential In E, exp (22)
equation and the same source of uncertainty represent-
ed by the Brownian motion W(t). The state at each
date consists of forward rates of all possible maturities
even though there is a single source of uncertainty. This For a proof, see Amin and Bodurtha [1995].
feature inherently makes the model path-dependent, HJM derive the equation for a (t, T) within the con-
except in special cases for which all the forward rates text of the continuous-time model. One may use this
can be written as fimctions of a single forward rate and continuous-time limit, which has a simpler represen-
time (the Ho-Lee [1986] model or the Vasicek [I9771 tation than (22), but expected bond prices from the
model are examples of these special cases). next period discounted by the single-period interest
Path-independent models of the type studied rate then do not exactly equal their current price.
earlier are not feasible, and we have to rely on a path- This error is of first order, and can cause large errors
dependent implementation. A major advantage of a in computing option prices. From a numerical per-
path-dependent implementation is that it is almost spective, it is preferable to use (22), which guarantees
completely general: We can specify any volatility that all bond prices today equal their expected dis-
function that we desire. One feasible implementation counted values from the next period.

SUMMER 1995 THE JOURNAL OF DERIVATWES 43


In (22), a (t, T) does not depend only on time equal to ZN, and the cumulative number of states is
or only on the volatility of the forward rate of maturi-
ty T; it depends on the volatility of other rates as well. 5’
equal to . The number of states for different values
Since the value of the forward rate of maturity T at i=O

any given date t depends on the cumulative value of a of N is given in Exhibit 5. The model is feasible with
(u, T) for u < t, the dependence of a (u, T) on the only fifteen to twenty time steps.
state makes the cumulative drift path-dependent; i.e., Even with so few time steps, it is possible to
the sequence in which the different values of X(t) are compute accurate option prices with maturities up to
realized affects the forward rates at any future date. ten years.6 Since the path-dependent tree includes a
Correspondingly, even if the dispersion term is large number of nodes, it is very dense. So, if we
path-independent, the model will be path-dependent. choose the points at each time step carefully, the dis-
Therefore, a model of the form (21) necessarily crete-time distribution approximates the continuous-
requires a path-dependent discrete-time model. time limiting distribution quite well.
Since our model is path-dependent, the tree One scheme for choosing the state points is to
representing the evolution of the term structure of choose linearly increasing or decreasing time steps
forward interest rates is “not recombining” as in such that the ratio of the largest time step to the
Exhibit 3. This tree is represented in Exhibit 4. Note smallest time step is between 2 and 3. The efficacy of
that the state (A, B) corresponding to state A at date this approach is illustrated in Exhibit 6. This figure
h and state B at date 2h is not the same as state (B, plots the terminal cumulative distribution function
A), which corresponds to state B at date h and state A obtained using the discrete-time path-dependent
at date 2h. model with ten time steps (dotted line) and the theo-
With a two-point distribution for X(t) as in retical cumulative distribution function (solid line).
Example 3, the number of states after time step N is The ratio of the maximum to the minimum time step
used to generate this figure is 3.
EXHIBIT 4 For simplicity, I have plotted a distribution that
STATE SPACEFORA THREE-PERIOD PATH-DEPENDENT approximates Brownian motion at some future date
IC~ODELWTII Two POSSIBLEINCRE~WWS(A AND B) AT and have scaled the axes in terms of the standard devi-
EACH DATE ation of the Brownian motion. Therefore, the graph is
independent of any fixed maturity date.
It is apparent from the graph that the cumula-
tive density function is approximated extremely well
by the scheme suggested above. With more compli-
cated schemes, the approximation can be improved
further. With these schemes, option prices are typical-

<
ABA ly within 1% or 2% of their limiting values.
AB For a description of implementing path-depen-
dent models with multiple state variables, see Amin
ABB and Bodurtha [ 19951.
0
BAA
III. SUMMARY
NBA
< I have described a large class of methods for
BAB implementing multivariate option pricing models
BBA based on diffusion processes. The path-independent
BB and state space models demonstrated here are very
intuitive and simple to implement. The path-depen-
< BBB dent model is more complicated and requires signifi-

44 OPTION PRICING TREES SUMMER 1995


additlonal variables that keep track of the path dependence.
‘This trick of changing the time works if the
option has an infinite maturity and the interest rate is con-
Number of Steps Cumulative Nodes stant, becausethese two problems then become irrelevant.
5 63 ‘A reasonable spacing is some fraction (say, 0.1) of
10 2,047 a&, where Ti is some average value of d (t, S(t)) in the
15 65,535 state spaceof interest.
20 2,097,151 “A second potential problem is that the increments
to the process Y(t) specified above may cause the discrete-
50 2.25 x 10’s
time process to have values that are not permissible for the
100 2.53 x 103*
continuous-time process. The problem can be solved by
truncating the processat suitable boundaries.
6With additional tricks, we can make it work well
cant programming effort, yet is still feasible even for
even for longer maturities.
valuing long-term options. Its advantage lies in its
generality.
REFERENCES
ENDNOTES e.

Amin, K.I. “On the Computation of Continuous-Time


Options Prices with Discrete Approximations.” Journal of
‘An early exercise strategy is any rule that speci-
Fi’inancialand Quantitative Atlalysis, 26 (1991), pp. 477-496.
fies, only on the basis of current and past information,
when an option should be exercised.
Amin, K.I., and James N. Bodurtha, Jr. “Discrete-Time
2We also require that the model include the same
American Option Valuation with Stochastic Interest
number of state variables at each date asthe original contin-
Rates.” Review of Financial Studies,8 (1995), pp. 193-234.
uous-time model. Some path-dependent models can be
made path-independent by augmenting the state space by
Boyle, Phelim, J. Evnine, and S. Gibbs. “Numerical
Evaluation of Multivariate Contingent Claims.” Review of
EXHIBIT 6 Finuncial Sturfies,2 (1989), pp. 241-250.
CIJMULATIVEDISTRIBWION FUNCIION OF THE
TERMINAL DISTRIBUIION OF A PXIW-DEPENDENT Cox, J.C.. S.A. Ross, and M. Rubinstein. “Option Pricing:
APPROXIMATION(DOPED LINE) TO A A Simplified Approach.” Journal of Firranrial Economics,7
BROWNIANMOTION RELATIVE TO THE ACXJAL (1979), pp. 229-264.
DISTRIBUTION (SOINI LINI:,) WITH TEN TIME STEPS
Heath, D., R. Jarrow, and A. Morton. “Bond Pricing and
the Term-Structure of Interest Rates: A New
Methodology.” Econometrica, 60 (1992), pp. 77-105.

Ho, T.S., R.C. Stapleton, and M.G. Subrahmanyam.


“Multivariate Binomial Approximations for Asset Prices
with Non-Stationary Variance and Covariance
Characteristics.” Working Paper, Stem School of Business,
New York University, 1993.

Ho, T.S.Y., and S.-B. Lee. “Term Structure Movements


and Pricing Interest Rate Contingent Claims.” Journal of
Finance,41 (1986), pp. 1011-1029.

Kushner, H.B. Probability Methods for Approximations in


Stochastic Control and for Elliptic Equations. New York:
Academic Press, 1977.

SUMMER 19% THE JOURNAL OF DERNATNES 45


Nelson, D.B., and K. Ramaswamy. “Simple Binomial Flannety. R’umeriall Recipes
in C. Cambridge: Cambridge
Processes as Diffusion Approximations in Financial University Press, 1992.
Models.” Review of Fimthd Studies, 3 (1990). pp. 393-
430. Vasicek, O.A. “An Equilibrium Characterization of the
Term Structure.” Journal $ Financial Econnmics, 5 (1977),
Press, W.H., S.A. Teukolsky, W.T. Vetterling, and B.P. pp. 177-188.

46 OPTION PRICING TREES SUMMER 1995