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A copula-based approach for generating lattices

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  • Tianyang Wang
  • James Dyer
  • Warren Hahn

Abstract

Discrete approximations such as binomial and trinomial lattices have been developed to model the intertemporal dynamics of variables in a way that also allows contingent decisions to be included at the appropriate increments in time. In this paper we present an approach for developing these types of models based on copulas. In addition to ease of implementation, a primary benefit of this approach is its generality, and we show that various binomial and trinomial approximation methods for valuing contingent claim securities in the literature are special cases of this approach, each based on a choice of a particular set of probability and/or branching parameters. Because this approach encompasses these and other cases as feasible solutions, we also show how it can be used to optimize the construction of lattices so that discretization error is minimized, and we demonstrate its application for an option pricing example. Copyright Springer Science+Business Media New York 2015

Suggested Citation

  • Tianyang Wang & James Dyer & Warren Hahn, 2015. "A copula-based approach for generating lattices," Review of Derivatives Research, Springer, vol. 18(3), pages 263-289, October.
    • Handle: RePEc:kap:revdev:v:18:y:2015:i:3:p:263-289
    DOI: 10.1007/s11147-015-9111-x
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    Cited by:

    1. Seiji Harikae & James S. Dyer & Tianyang Wang, 2021. "Valuing Real Options in the Volatile Real World," Production and Operations Management, Production and Operations Management Society, vol. 30(1), pages 171-189, January.

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    More about this item

    Keywords

    Stochastic processes; Discrete models; Option pricing; Copulas; G13; C10;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General

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