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Simple Binomial Processes as Diffusion Approximations in Financial Models (Reprint 003)

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  • Daniel B. Nelson
  • Krishna Ramaswamy

Abstract

A binomial approximation to a diffusion is defined as computationally simple if the number of nodes grows at most linearly in the number of time intervals. This paper shows how to construct computationally simple binomial processes which converge weakly to commonly employed diffusions in financial models. It also demonstrates the convergence of the sequence of bond and European option prices from these processes to the corresponding values in the diffusion limit. Numerical examples from the Constant Elasticity of Variance stock price and the Cox, Ingersoll, and Ross discount bond price are provided.

Suggested Citation

  • Daniel B. Nelson & Krishna Ramaswamy, "undated". "Simple Binomial Processes as Diffusion Approximations in Financial Models (Reprint 003)," Rodney L. White Center for Financial Research Working Papers 30-89, Wharton School Rodney L. White Center for Financial Research.
    • Handle: RePEc:fth:pennfi:30-89
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    Cited by:

    1. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.

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